Working with clients who are getting into real estate investing can be an optimal situation for you both. These clients need a seasoned tax professional who can advise on how to reduce taxes on their investment income. As a tax professional, it’s always a good thing when your clients are making more money and therefore need more sophisticated tax planning services. Are you up for the challenge?
The first thing to consider when your client takes on a real estate investment is how to structure it. Taxpayers may not realize that they often can save much more on taxes by setting up a legal entity for their real estate holdings rather than paying taxes as an individual. In our last blog, we discussed the pros and cons of the most common entity types: LLCs, partnerships, C corporations, and S corporations. Today, we’ll look at another alternative that may work for your clients: getting involved in a real estate investment trust (REIT).
Become a Certified Tax Planner! Fully immersive year-round training and guidance on how to implement sophisticated tax planning strategies. Drastically reduce your clients’ taxes and earn premium fees!
The Limits of a REIT
What exactly is a real estate investment trust? This type of company owns, operates, or finances income-generating real estate, funded by selling shares to make these investments. The REIT was first established in 1960 to allow investors, especially smaller investors to set up a type of mutual fund for real estate. This allows investors to get involved in much bigger deals even if they don’t personally have the amount of capital that would normally allow for that. A REIT creates a vehicle for 150 different people to combine their resources and together invest in a $100 million project.
However, like any other entity type, a REIT comes with both pros and cons. Let’s first take a look at the limitations on how a REIT must be structured:
● In a REIT, 75% of the assets must be real property. This restricts sneaky investors from attempting to gain the benefits of a REIT without using it for its primary purpose—real estate holding.
● In a REIT, 85% of the income must be passive income.
● A REIT must be widely held with 100 or more shareholders. Additionally, five or fewer individuals cannot own 50% or more of the REIT. This means individuals, family offices, and closely held companies cannot directly own an entire REIT.
● A REIT must distribute its income among all shareholders
The Benefits of a REIT
If your client can accommodate these requirements, a REIT also comes with a number of benefits. From a legal perspective, a REIT is structured as a corporation, but it also sees some of the advantages of a pass-through entity. For instance, the REIT receives a deduction for its distribution, offsetting the cost of corporate tax. Of course, the profits can be significantly higher with a REIT because as a collective the investors can secure larger properties. A REIT can invest in developing or redeveloping a 50-story condominium tower, a shopping mall, or another commercial property where no individual owner could hope to pick up such a project. With a REIT, investors can lower their risk and financial commitment and still enjoy high rewards.
A REIT can also be a great option for clients who were considering a 1031 exchange but cannot quite meet the requirements of that “like-kind exchange.” To recap, section 1031 allows real estate investors to sell a property and reinvest that money into a new “like-kind” property. The main benefit of this is to defer paying capital gains tax, since this is treated like a swap between similar assets and not an outright sale. For investors who cannot make that “like-kind” requirement work, a REIT is another way to switch up your portfolio by allowing you to invest in more properties or larger properties while sharing the tax burden with other investors.
When an UPREIT might be right
Another option for clients seeking more ownership of a property is the Umbrella Partnership Real Estate Investment Trust (UPREIT). This type of trust allows a property owner to contribute their property to a master partnership in exchange for partnership interests. This functions similarly to a joint venture. The REIT typically manages all the property assets, and the original owners get the benefit of diversifying their investments and deferring capital gains tax on their appreciated property.
To determine if an UPREIT could be a good fit for your client, ask these key questions:
● What are your plans for the money once you sell the property?
● Are you looking for immediate cash or would you prefer to grow your wealth over time?
● Could you benefit from regular profit distributions at this stage in your life (e.g. if you are planning to retire soon)?
● Are you interested in expanding your investment portfolio?
If your client is more interested in increasing their cash flow and expanding their investments over time, an UPREIT could be the perfect opportunity. Unless they are in need of the immediate cash that would come from an outright sale, an UPREIT allows them to defer taxes, join a bigger portfolio of properties, and enjoy regular distributions just by diluting their ownership of the property and joining this partnership.
Summary
Newer investors may never have even heard of a REIT or an UPREIT, much less know about the tax benefits that come with each. This is where the help of a tax professional comes into play. By understanding your client’s tax situation and future investment goals, you can steer them toward the entity structure that will serve them best. To learn more about these and other tax savings opportunities for investors, sign up to become a Certified Tax Planner today.
Don’t miss the rest of our 4 part Real Estate Investment series!
