8 Surprising Reasons REITs Will Save You Big On Taxes

seekingalpha05-30

REITs are historically cheap right now.They also offer significant tax benefits.Here are 8 REIT tax advantages that are underappreciated.stocknshares/E+ via Getty Images It is no secret that I am very...

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IYR). I regularly write articles about some of my favorite REIT investment opportunities, and I dedicate about 50% of my portfolio into them. Why? In short, I think that they offer the best risk-to-reward in the present market. They are currently priced at their lowest valuations in over a decade due to fears of rising interest rates, but the reality is that most REITs are not heavily impacted because they use little leverage, have long debt maturities, and enjoy growing rents. This explains why most REITs have kept growing their cash flows and dividends in 2022, and 2023 and will again in 2024, even despite their crashing share prices. Data by YCharts BSR REIT So to put it simply: REITs offer today the opportunity to buy real estate at a steep discount to its fair value, and historically, it has generally been a good idea to buy REITs whenever they were offered at such low valuations: Janus & Henderson But not everyone agrees, and one pushback point that I keep regularly receiving is that \"REITs are not tax-efficient.\" This thought stems from the fact that REIT dividend income is generally classified as \"ordinary income\" which is taxed at a higher rate than the dividend income of most other stocks. Moreover, real estate investors will often argue that REITs are worse because they cannot use non-cash depreciation and/or 1031 exchanges to defer taxes. But this is nothing more than a misconception in my opinion. I actually think that REITs are highly tax-efficient investments, and here are 8 reasons why: Reason #1: No corporate tax The first advantage that often gets overlooked is that REITs pay 0 corporate taxes as long as they meet certain requirements in the assets that they own and how much dividend income they pay out. Investors tend to forget about corporate taxes because you are not directly paying them yourself, but as a shareholder, you are indirectly paying these taxes so they cannot be ignored. This is a major tax advantage that's unique to REITs. It is quite incredible to get the \"limited liability\" and other benefits of a corporation without having to pay any taxes for it. Reason #2: REITs retain a lot of cash flow And one major benefit of not paying corporate taxes is that it allows REIT investors to avoid paying taxes on any cash flow that the REIT retains to reinvest in growth. If you own the property directly, you would be taxed on the total cash flow, but in this case, REIT investors are only taxed on the portion that's paid out to them, and whatever the REIT retains isn't taxed. Many here will think that this isn't a major advantage, since REITs must pay 90% of their taxable income to shareholders in the form of dividends. But this is just another misconception. Yes, it is true that this rule exists, but note that it applies to \"taxable income\", not to cash flow. Taxable income is often very low in the case of REITs because they can apply non-cash depreciation against it. As a result, most REITs will only pay 50-75% of their cash flow in the form of dividends. Some REITs like SBA Communications (SBAC) and Boardwalk (BEI.UN:CA / OTCPK:BOWFF) have a payout ratio as low as 35%. This means that 65% of their cash flow doesn't get taxed and the REIT then gets to reinvest it into new acquisitions, which will grow the cash flow, and ultimately, make the company more valuable. Reason #3: \"Return of capital\" Then you should also note that not all dividend income is classified as \"ordinary income\". Very often, REITs will classify a portion of the dividend income as \"return of capital\", which isn't taxed either. It lowers your cost basis instead, allowing you to defer the taxes to the day when you sell your shares in the future. It is similar to \"depreciation\" for private real estate. Some REITs like BSR REIT (OTCPK:BSRTF; HOM.U:CA) will classify all of their dividend payments as return of capital, allowing you to skip all taxes on this income. Reason #4: 20% deduction Then the portion of the dividend that's actually taxed as \"ordinary income\" will also enjoy a 20% deduction, which essentially lowers your effective tax rate on this income. Reason #5: No property transfer taxes A lot of jurisdictions have significant property transfer taxes that you need to pay either when you buy or sell a property. In some countries like Germany, these taxes can be up to 5% of the property value. But by buying shares of a REIT, you get to skip all of these taxes as well. You are simply buying an interest in a pre-existing portfolio. Reason #6: Lower property taxes REITs also enjoy significant economies of scale because of their size, and this even applies to property taxes. They will often employ in-house lawyers who will fight off property tax hikes. You, of course, couldn't do that as a private real estate investor, as it would be far too expensive to hire a lawyer without having the scale to do it. Reason #7: Growth and appreciation are tax-deferred REITs are often falsely perceived to be boring \"income vehicles\" with little growth. This misconception stems from the 90% payout rule, which leads many to think that REITs don't have the cash to grow. But as we explained earlier, this is just a misunderstanding. Most REITs retain significant cash flow to acquire or develop new properties. Moreover, most REITs focus on lower-yielding, rapidly growing properties like data centers and e-commerce warehouses that enjoy strong rent growth. Finally, REITs may at times also be able to access the public markets to raise more capital and reinvest it at a positive spread. This explains why, historically, about 1/2 or even 2/3 of REIT total returns have come from growth and appreciation. You don't get to 12-15% average annual total returns by simply paying a dividend and not enjoying any growth: NAREIT Most of that is growth and appreciation, which is fully tax-deferred. Reason #8: Tax-deferred accounts So by now, we have established that REITs pay no corporate tax... they retain a big chunk of their cash flow which isn't taxed... they classify a portion of their dividend as return of capital... they enjoy a 20% deduction... there is no property transfer taxes... REITs get to mitigate the impact of property taxes... and finally, a big portion of the total returns are growth and appreciation. This makes REITs highly tax-efficient. But if that's not enough for you, you could simply hold your REITs in a tax-deferred account and skip all taxes very efficiently and still be able to get in and out of REITs whenever you want. Closing Note The takeaway here is that the tax efficiency of REITs is greatly underestimated in my opinion. In fact, I pay less taxes when investing in REITs than in private real estate, and this is one of the many reasons why I think that REITs are great investments.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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