The 2017 tax act added §199A to the Internal Revenue Code and, with it, two complementary tax deductions:
- A deduction of up to 20% of the income from a limited partnership, limited liability company, or other “pass through” entity.
- A deduction equal to 20% of “qualified REIT dividends.”
Which is better for sponsors and investors?
As described here, the 20% deduction for pass-through entities is enormously complicated. Most important, the deduction can be limited for taxpayers whose personal taxable income exceeds $157,500 ($315,000 for a married couple filing jointly). These limits depend on the W-2 wages paid by the pass-through entity (not much for most real estate syndications) and the cost of the entity’s depreciable property (pretty substantial for most real estate syndications). And, naturally, those limits are themselves subject to special rules and definitions.
In contrast, the 20% deduction for qualified REIT dividends (which includes most dividends from REITs, other than capital gain dividends) is straightforward, with no cutdown for higher-income taxpayers.
Does that mean §199A favors REITs over LLCs and other pass-through entities? Not necessarily.
The key is that most real estate syndications don’t generate taxable income. Typically, the depreciation from the building “shelters” the net cash flow, at least during the early years of the project. The tax-favored nature of real estate is, in fact, part of what makes it such an attractive investment in the first place.
If an investor in an LLC is receiving cash flow from the syndication and paying zero tax, the 20% deduction of §199A is irrelevant. And, for that matter, so is the 20% deduction for REIT dividends. If a REIT isn’t generating taxable income because its cash flow is sheltered by depreciation, then its distribution will probably treated as a non-taxable return of capital rather than a taxable dividend.
As discussed here, the key advantage of a REIT over an LLC or other pass-through entity is that the LLC investor receives a complicated K-1 while a REIT investor receives a simple 1099. The relative simplicity of the 20% deduction for REIT dividends over the 20% deduction for pass-through entities is nice, but wouldn’t tip the balance in favor of a REIT by itself.
Questions? Let me know.
