Real estate fund sponsors that typically choose limited partnership or limited liability company structures for their fund entities might want to give REITs another look. With the addition of Section 199A to the Internal Revenue Code by the Tax Cuts and Jobs Act of 2017, REIT investors stand to benefit from a tax deduction on distributions that is largely unavailable to investors in LP or LLC real estate funds. That benefit incentivizes potential investors to favor REIT structures, which could lead to more effective and efficient capital-raising efforts for sponsors who offer REITs.
In general, Section 199A allows a deduction equal to 20 percent of a non-corporate taxpayer’s combined qualified business income, or QBI. QBI includes income from certain trades or businesses operated in a pass-through entity, as well as qualified REIT dividends (dividends not subject to favorable capital gains rates).
Section 199A deductions attributable to QBI from sources other than qualified REIT dividends are subject to limitations that can be a particularly significant disadvantage to non-REIT real estate fund investors. The two main limitations are:
- The deduction is not available for passive investments like triple net lease properties; and
- The deduction is limited to the greater of: (a) 50 percent of employee wages paid with respect to the trade or business, or (b) the sum of 25 percent of employee wages plus 2.5 percent of the unadjusted tax basis of qualified property.
Because many real estate funds have few (if any) employees, investing in a real estate fund structured as an LP or LLC may be less likely (depending on basis of qualified property) to qualify a taxpayer for the full benefits of the Section 199A deduction. Moreover, investors in non-REIT real estate funds that primarily hold triple net lease properties or that are otherwise not “engaged in a business” cannot apply the Section 199A deduction to distributions from those funds.
Conversely, the 20 percent deduction is available to REIT investors for both passive and active investments and without regard to the limitations discussed above applicable to non-REIT investors.
The special provision for REITs in Section 199A reduces the effective tax rate on qualified REIT dividends for individuals in the highest ordinary income tax bracket from 37 percent to 29.6 percent. Because that deduction is often unavailable or very limited for non-REIT real estate funds and direct real estate investments, investors seeking to invest in a diversified real estate portfolio now have greater incentive to choose REITs. In the competitive market for attracting investment dollars, that edge might be the difference between a successful capital raise and one that falls short of expectations.
Currently, the benefit of Section 199A is scheduled to sunset at the end of 2025.