On Wednesday, Treasury Secretary Steven Mnuchin and National Economic Director Gary Cohn laid out the basic principals of the White House’s tax reform plan. While scant on many important details, it hinted at some major changes: Taxes for corporations and other businesses, including pass-through entities like LLCs and S corporations, would go from the current top marginal rate of 35 percent (plus local tax) to 15 percent, and individual rates would go from a seven-bracket system to just three, a massive shift that could change the incentive structure for numerous investments.
One of the investment vehicles that could be significantly impacted by these tax shakeups is the real estate investment trust, or REIT.
REITs do not pay corporate tax and in exchange are required to pay out 90 percent of their returns to stockholders, mostly in the form of dividends. Because of that tax-exempt status, REITs offer yields that are higher than the average S&P 500 corporate stock. Their shareholders, however, pay ordinary income tax on those dividends, with a maximum rate of 39.6 percent under current law.
“With regular taxable corporations, dividends paid by them are currently taxable at capital gains rates, so 20 percent [plus the 3.8 percent net investment income tax introduced by President Obama]” said Mark Kirshenbaum, an attorney at Goodwin Procter who specializes in tax structures for real estate companies. “Ordinary dividends paid by REITs aren’t eligible for that.”
Trump’s 15-percent business rate is expected to apply to corporations and pass-through entities. Because REITs are not themselves taxed and instead pass through liability to stockholders, it is possible (though not likely) they would be allowed that 15 percent rate by the Trump tax plan. If not, it could make REITs a less attractive investment option than before.
“If they don’t do anything on the dividends paid out by REITs, dividends continue to be ordinary income,” Kirshenbaum said. “Looking at that in isolation, an individual would be better off owning real estate through a corporation. So that’s where the benefit of REITs, at least for individual taxpayers, could go away.”
Sandy Davis, a tax attorney at the Akerman law firm, said the huge drop in the corporate taxes, with no changes to REIT dividend taxation, could make the decision to form either a REIT or a normal corporation a close call. If bosses chose the typical corporate route, the company would first owe just 15 percent in corporate taxes and stockholders would then pay individual taxes from dividends or capital gains after that, and in some cases would come out the other end better than they would have as a REIT.
“The burden of two levels of taxation is reduced, so it’s possible that the comparative differential of tax burden might narrow,” Davis said, but cautioned that the math would vary significantly case by case. “Based on the lack of clarity so far in the Trump plan, it’s hard to make a comparison,” he said.
It’s also not known how the tax plan would affect the ability of REITs to depreciate building values for tax purposes or deduct interest from loan payments on buildings, Davis noted, which under the current rules results in tax savings for REIT shareholders on certain non-dividend distributions. That’s a big factor in how much taxes investors owe – regardless of where rates are set.
For specifics, it’ll be a game of wait and see what comes through Congress. Most experts say a 15 percent corporate rate is an unlikely legislative outcome and the plan last floated by House Republicans only went as far a 20 percent rate.