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Tax Reform Could Drive REIT Shares Higher

By Matthew Frankel, CFP® - Dec 8, 2017 at 7:33AM

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Here's one reason why 2018 could be a much better year for REITs than 2017 was.

Despite the stock market's strong performance in 2017, real estate investments broadly haven't had a great year. There are several reasons for this, including rising interest rates and sector-specific headwinds  such as retail bankruptcies and oversupply fears in some industries, which are hitting certain types of REITs.

While a number of factors will be keys to how the real estate sector performs in 2018, one potential catalyst that could boost the values of real estate investment trusts is tax reform. Both the House and Senate versions of the Tax Cuts and Jobs Act include a proposal to cut the tax rates on REIT distributions significantly, which could drive investor interest in those stocks.

Black notebook labeled tax reform.

Image Source: Getty Images.

REIT dividends are classified as pass-through income

REITs are taxed differently than most other types of companies. As long as they pay out at least 90% of their taxable income to shareholders, they aren't taxed at the corporate level. So, the lower proposed corporate tax rate wouldn't change matters for REITs.

However, the dividends they pay to shareholders are not treated like other dividends, which can qualify for special tax rates. REIT distributions are generally counted as pass-through business income, and are therefore taxed at the recipient's ordinary income rate under current tax law. https://www.reit.com/investing/investing-reits/taxes-and-reit-investment

This is where the GOP's tax plan could help REIT investors. Both versions contain tax breaks for pass-through business income, although the proposals are significantly different at this point. https://www.nytimes.com/2017/12/05/business/economy/tax-bill-real-estate.html

The House wants to lower pass-through rates

The version of the tax bill passed by the House of Representatives has an easy-to-understand proposal for pass-through income: It lowers the top income tax rate for pass-through entities (like REITs) to 25% -- the marginal rate paid by married couples on income between $75,900 and $153,100. Currently, the income tax rate tops out at 39.6% for household earnings over $470,700, so this would be a big reduction for higher-income taxpayers.

The Senate wants a pass-through deduction

On the other hand, the Senate's version of the bill would continue to tax pass-through business income at the individual tax rates. However, the plan would allow a deduction of 23% of pass-through income; the remainder would be subject to taxation.

In addition, the Senate's plan would lower most marginal tax rates, so the combination of this produces significantly lower potential tax rates for REIT dividend income.

Here's what this could mean to REIT investors:

Current-Law Marginal Tax Rates

Senate's Proposed Tax Rates

Effective Pass-Through Tax Rates, After 23% Deduction

10%

10%

7.7%

15%

12%

9.2%

25%

22%

16.9%

28%

24%

18.5%

33%

32%

24.6%

35%

35%

27%

39.6%

38.5%

29.6%

Data Source: IRS, Tax Cuts and Jobs Act (Senate version), and author's own calculations. Note: The income thresholds for current and proposed brackets don't match up exactly.

Either way, REITs would become more appealing in taxable accounts

Because of their relatively high dividends, it has made more sense to hold REITs in tax-advantaged accounts such as IRAs whenever possible, and to be clear, that will continue to be true.

However, many investors do own REITs in taxable brokerage accounts, and these investors could see substantial tax savings in 2018. With the Senate’s version, there would be a tax cut for REIT shareholders of all income levels, while the House’s version gives all benefit to the small fraction of Americans who are in a marginal tax bracket above 25%. (That demographic, it's worth noting, includes the lion's share of direct REIT investors already.)

So, this could make owning REITs more attractive to investors who have traditionally stuck with stocks whose dividends qualified for more favorable rates. This could cause a surge in REIT investment and drive prices higher in 2018.

Just one piece of the performance puzzle

Finally, it's important to mention that there are many factors that influence the performance of REIT stocks. In addition to the obvious company-specific issues like growth and profitability, there are also macroeconomic matters such as how quickly interest rates rise, or the demand for rental space broadly.

The bottom line is that a tax cut could boost the value of REIT payouts, but it's just one of many factors that will determine how the sector, and individual REITs, perform in 2018 and beyond.

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