What are the tax advantages of real estate funds?

As the investing adage goes: it's not what you make, it's what you keep. For taxable individuals and institutions, real estate investments may offer tax attributes that can be taken into consideration when comparing headline returns against other asset classes.

These tax attributes may apply to investors in public REITs as well as non-traded REITs and other private real estate vehicles.

A layer cake of deductions

Real estate held as an investment is generally taxed differently than many other assets. The tax benefits and impacts come in layers, and it's worth knowing what each one is made of.

1. Property taxes and a range of other expenses associated with investing in real estate are commonly deductible in determining taxable rental income—though the benefit to any given investor may depend on the ownership structure and applicable tax limitations.
2. Then there’s depreciation, arguably the most distinctive attribute of the asset class. For tax purposes, buildings are generally treated as having a finite useful life, and depreciation each year may reduce taxable income even in periods when a property is performing well. The schedule of depreciation differs by property type, and land itself is generally not depreciable.
3. Furthermore, the Tax Cuts and Jobs Act introduced a deduction for certain qualified REIT dividends. Eligible individual investors may be able to deduct up to 20% of qualified REIT dividends, subject to applicable limitations and current law.

Deferring the bill

After taking into account operating expenses and depreciation, a REIT may have taxable income that is lower than its cash available to distribute. When a distribution exceeds the amount treated as a taxable dividend, a portion may be characterized as return of capital (ROC).

Helpfully, ROC is generally not taxable when received, to the extent of the investor's tax basis. That is not the same thing as escaping tax altogether. It generally reduces the investor’s tax basis, which may increase the taxable gain recognized on a later sale or redemption. Put simply, the timing of the tax may shift into the future rather than disappear, and for many investors, timing has value as it allows them to stay fully invested in the market.

For some high-income taxpayers, the top federal long-term capital gains rate may be lower than the top federal ordinary income tax rate, which can make deferral more valuable. Actual outcomes vary based on holding period, distribution character, depreciation recapture, net investment income tax, state and local taxes and the investor's broader tax profile.

Comparing apples to apples

Municipal bond investors have it comparatively easy. With a relatively straightforward tax exemption, a tax-equivalent yield can show at a glance how a muni’s return stacks up against a taxable corporate bond.

If municipal bonds allow for an apples-to-apples comparison, real estate is more of a fruit basket, and no two baskets look alike. Real estate investments may have multiple tax attributes, and evaluating their after-tax impact can be complex. Investors should consult their own tax advisors to understand how the tax treatment of a non-traded REIT or other real estate vehicle may apply to their individual circumstances. A financial advisor can also help investors think through how potential after-tax returns might compare with other options.

Tax considerations

The following information is provided for educational purposes only and is not intended to be, and should not be relied upon as, tax, legal, or accounting advice. 

Real estate investments (including public REITs, non-traded REITs, and other private real estate vehicles) can have tax characteristics that differ from many other asset classes, and these characteristics may be relevant when evaluating after-tax returns. 

Tax benefits and outcomes may depend on the investor’s ownership structure and on applicable tax rules and limitations. Deductions may include property taxes and other expenses used in determining taxable rental income, and depreciation may reduce taxable income even when a property is performing well; depreciation schedules vary by property type and land is generally not depreciable. 

Distributions may be characterized in whole or in part as return of capital (“ROC”) when distributions exceed the amount treated as a taxable dividend; ROC is generally not taxable when received to the extent of the investor’s tax basis, but it generally reduces tax basis and may increase taxable gain upon a later sale or redemption. Any tax benefit may reflect deferral (timing) rather than elimination of tax. 

Actual tax results vary based on factors including holding period, distribution character, depreciation recapture, net investment income tax, state and local taxes, and the investor’s overall tax profile; the relative value of deferral may also vary depending on whether long-term capital gains rates differ from ordinary income tax rates for the investor. 

Investors should consult their own tax advisors regarding how any non-traded REIT or other real estate vehicle would be treated for tax purposes in light of their specific circumstances, and a financial advisor can help evaluate potential after-tax returns versus other options.

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