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Recent tax legislation, informally known as the Tax Cuts and Jobs Act (the “Act”), will have a widespread impact on individuals and corporations, including real estate investment trusts (“REITs”) and their shareholders. In general, the Act impacts REITs and their shareholders by: (i) lowering the effective rate of tax applicable to dividend income received from a REIT by its shareholders, (ii) limiting the deduction for interest paid, (iii) allowing full expensing of certain property, and (iv) limiting the compensation deduction for certain individuals.
Individuals and certain other non-corporate taxpayers will be entitled to claim a deduction equal to 20% of qualified REIT dividend income, which does not include income attributable to capital gain dividends or qualified dividend income from a regular corporation (such as a taxable REIT subsidiary), in computing their taxable income. Thus, the maximum U.S. federal individual income tax rate imposed on qualified REIT dividend income is 29.6% or 33.4% if the taxpayer is subject to the 3.8% Medicare tax on unearned income. The deduction may not exceed the taxpayer’s taxable income and further limitations may apply if the taxpayer has income from an investment in other pass-through entities engaged in certain specified service businesses. While the regular corporate income tax rate has been reduced to 21%, the combined (corporate and shareholder) maximum effective tax rate on corporate earnings after distribution as a dividend to shareholders is 36.8% or 39.8% if the Medicare tax applies. On the other hand, qualified REIT dividend income is taxed once, i.e., at a maximum of 29.6% or 33.4% if the Medicare tax applies, which is approximately 6-7% lower than effective rate of tax imposed on distributed earnings of a regular corporation. Unlike a REIT, however, a regular corporation is not required to distribute all of its earnings currently and a regular corporation generally may retain a much higher percentage of its earnings for reinvestment at lower rates of current income taxation.
Other tax provisions of the Act likely to have an impact on the computation of a REIT’s taxable income (before any deduction for dividends paid to its shareholders) include the 30% limitation on the deduction for interest paid by the REIT (which can be avoided if the REIT elects the alternative depreciation system to depreciate its real property and qualified improvements thereto), the provisions allowing for full expensing of qualified property placed in service prior to 2022 (this deduction is reduced by 20% per year beginning in 2023), and the changes made limiting the deduction for compensation paid to the principal executive and financial officers, and the next three (3) highest compensated officers of the REIT. Other provisions that could impact the amount of a REIT’s taxable income (before deduction for dividends paid to shareholders) include additional limitations on certain travel and entertainment expenses, denial of a deduction for settlement payments in connection with a sexual harassment or sexual abuse claim, and limitations on the deduction for lobbying expenses before local governmental bodies.
A more complete summary of the provisions of the Act impacting a REIT and its shareholders can be obtained here .