Sept. 22, 2021

A version of this article previously appeared on EideBailly.com.

By Sonja Sparks, CPA

With investment real estate at an all-time high in Sioux Falls, it’s important to think about how your investment fund can stand out in this competitive market. With all the developments going up around town and the housing marketing booming, read on to learn how you can have an edge in the Sioux Falls market.

In the real estate industry, the lifeblood of any investment project is capital. In an era when real estate investment is at an all-time high, it’s important for investment funds to be able to stand out to their potential investor pool. One such differentiator lies within a key question that most savvy investors ask of any structure: “What are the tax consequences?”

We typically see partnership structures with a preferred return for investors and a promote for sponsors, but that means there’s only so much variation a fund can provide to make their investment appealing from a tax perspective. With the abounding competition in the sector, partnerships need to start looking further outside of the box.

We see a lot of growth through the use of private real estate investment trusts, or REITs. These types of investment entities can be particularly enticing to certain investor groups because of the tax benefits they provide. It’s certainly not a new concept, but there has been a resurgence of the use of private REITs in recent years, making this an exciting trend worth exploring.

What is a REIT?

A REIT is a type of tax entity, organized as a corporation or trust, that owns income-producing real property. REITs can range from single-asset entities to well-diversified portfolio entities and can hold a wide variety of property types: anything from apartment buildings to skyscrapers and everything in between.

Most REITs trade on major stock exchanges and offer a number of benefits to investors. REITs are taxed as a corporation but also are afforded some of the benefits of a flow-through entity. In its simplest tax form, a REIT functions like a hybrid of the two and provides the best of both worlds.

There are a couple of reasons that partnerships are becoming more interested in REITs:

1. The 199A tax deduction is spurring interest for real estate investors to move their properties into REITs in order to qualify for the 20 percent deduction.
2. Foreign investments have become increasingly popular.

Diverging from a typical corporation

One of the biggest downfalls of a corporation is the double taxation of earnings. Income tax is paid at the corporate level when earned, and then tax is paid again on the dividends distributed to the shareholders.

REITs, however, are allowed an additional tax deduction for dividends paid to shareholders. That means to the extent the REIT pays dividends equal to taxable income, there is no tax liability at the REIT. In essence, earnings are passed through to the investors in real time and many see cash flow from their investment early on.

When the REIT makes distributions to shareholders, it has the ability to designate certain distributions as a return of capital rather than a taxable dividend, which can provide tax-deferred cash flow to the investors. If the REIT does make taxable distributions, the ordinary dividends paid to the shareholders are eligible for the qualified business income, or QBI, deduction at the shareholder level. That’s a deduction otherwise limited to flow-through distributions.

What investor types can benefit?

A wide variety of investor types can recognize benefits from investing in a REIT. The list below summarizes a few of the main advantages.

Foreign investors

• REITs function like a blocker corporation in a real estate investment fund, so setting up the REIT as the investment entity reduces the number of entities needed in the structure.
• Ordinary dividends from a REIT are not subject to foreign withholding.

IRA and other tax-exempt investors

• Dividends from a REIT do not constitute unrelated business taxable income, or UBTI.

Individual and trust investors

• Ordinary dividends are QBI-deduction eligible.
• Dividends related to the sale of real property by the REIT are designated as capital gain dividends and are eligible for capital gain rates.
• Regular cash flow for investors is possible as REITs pay out dividends to reduce their taxable income.
• Early distributions from a REIT can be classified as return of capital to the investor as opposed to being a taxable dividend.

 Why isn’t every real estate entity a REIT?

Though there are numerous benefits of using a private REIT in your real estate structure, this entity structure is not without its pitfalls. There are multiple organizational hurdles to overcome initially, as well as ongoing compliance requirements to consider.

Dive Deeper: Visit EideBailly.com for an in-depth look at state and local tax concerns.