8 Surprising Reasons REITs Will Save You Big on Taxes

It’s no secret that I’m very bullish on REITs (VNQ; IYR).

I regularly write articles about some of my favorite investment opportunities in REITs, and allocate about 50% of my portfolio to them.

Why?

In short, I think they offer the best risk-reward ratio in the current market. They are currently priced at their lowest valuations in more than a decade due to fears of rising interest rates, but the reality is that most REITs are not severely affected because they use little leverage, have long debt maturities, and enjoy increasing rents. This explains why most REITs will continue to grow their cash flows and dividends in 2022 and 2023 and will do so again in 2024, despite the collapse in their share prices.

Simply put: today’s REITs provide the opportunity to do just that Buying real estate at a significant discount to its fair value, historically, it has generally been a good idea to buy REITs when they are offered at such low valuations:

But not everyone agrees on that, and one of the pushback points I keep getting is that “REITs are not tax efficient.”

This thought stems from the fact that a REIT’s dividend income is generally classified as “ordinary income” which is taxed at a higher rate than the dividend income of most other stocks.

Furthermore, real estate investors often claim 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 believe that REITs are highly tax efficient investments, and here are 8 reasons why:

Reason #1: There is no corporate tax

The first advantage that is often overlooked is that REITs pay zero corporate taxes as long as they meet certain requirements in the assets they hold and the amount of dividend income they pay.

Investors tend to forget corporate taxes because you don’t pay them directly yourself, but as a shareholder, you pay these taxes indirectly so they can’t be ignored.

This is a significant tax advantage that is unique to REITs. It’s incredible that you get the “limited liability” and other benefits of a corporation without having to pay any taxes for it.

Reason #2: REITs hold a lot of cash flow

A major benefit of not paying corporate taxes is that it allows REIT investors to avoid paying taxes on any cash flow the REIT holds to reinvest in growth.

If you own the property outright, you will be taxed on the total cash flow, but in this case, REIT investors are only taxed on the portion paid to them, and anything the REIT keeps is not taxed.

Many here will think that this is not a huge advantage, as REITs must pay out 90% of their taxable income to shareholders in the form of dividends.

But this is just another misconception. Yes, it’s true that this rule exists, but note that it applies to “taxable income,” not cash flow. Taxable income is often very low in the case of REITs because they can apply non-cash depreciation to it.

As a result, most REITs will only pay out 50-75% of their cash flows in the form of dividends. Some REITs like SBA Communications (SBAC) and Boardwalk (BEI.UN:CA / OTCPK:BOWFF) have payout ratios as low as 35%. This means that 65% of their cash flow is not taxable, which the REIT will then reinvest in new acquisitions, which will increase cash flow and, ultimately, make the company more valuable.

Reason #3: “Return on Capital”

Then you should also note that not all dividend income is classified as “ordinary income.”

Often, REITs classify a portion of dividend income as a “return of capital,” which is also not subject to tax. It lowers your cost basis instead, allowing you to defer taxes until the day you sell your shares in the future.

It is similar to the “depreciation” of private real estate.

Some REITs like BSR REIT ( OTCPK:BSRTF ; HOM.U:CA ) will classify all of their dividend payments as a return of capital, allowing you to skip all taxes on that income.

Reason #4: 20% discount

Then the portion of earnings that is actually taxed as “ordinary income” will also enjoy the 20% deduction, essentially lowering the effective tax rate on that income.

Reason No. 5: There are no taxes on transfer of property

Many jurisdictions impose large property transfer taxes that you must pay when either buying or selling a property. In some countries, such as Germany, these taxes can reach 5% of the property value.

But by buying REIT shares, you can skip all those taxes, too. You simply buy a stake in a pre-existing portfolio.

Reason #6: Lower property taxes

REITs also enjoy significant economies of scale due to their size, and this even applies to property taxes.

They often hire in-house attorneys who fight high estate taxes. You, of course, cannot do this as a private real estate investor, because it would be too expensive to hire an attorney without having the scale to do so.

Reason #7: Growth and appreciation are tax deferred

REITs are often wrongly viewed as boring “income vehicles” with little growth. This misconception stems from the 90% payout rule, which leads many to believe that REITs don’t have the money to grow.

But as we explained earlier, this is just a misunderstanding. Most REITs reserve significant cash flow to purchase or develop new properties. Furthermore, most REITs focus on low-yielding, fast-growing properties such as data centers and e-commerce warehouses that have strong rental growth. Finally, REITs may sometimes be able to access the public markets to raise more capital and reinvest it at positive spreads.

This explains why, historically, about 1/2 or even 2/3 of total REIT returns have come from growth and appreciation. You can’t get 12-15% average annual returns by just paying a dividend and not enjoying any growth:

Most of that growth and currency appreciation is entirely tax deferred.

Reason #8: Deferred tax accounts

So, we’ve now established that REITs pay no corporate taxes… they keep a large portion of their cash flows untaxed… they classify a portion of their profits as a return of capital… and they enjoy a large portion of their profits. 20% discount… No property transfer taxes… REITs mitigate the impact of estate taxes… Finally, a large portion of total returns is growth and appreciation.

This makes REITs highly tax efficient.

But if that’s not enough for you, you can simply keep your REITs in a tax-deferred account and skip all the taxes very efficiently and still be able to move in and out of your REITs whenever you want.

Concluding note

The takeaway here is that the tax efficiency of REITs is greatly underestimated in my opinion.

In fact, I pay less in taxes when investing in REITs than I do with private real estate, which is one of the many reasons why I think REITs are great investments.

Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. exchange. Please be aware of the risks associated with these stocks.