President Biden and congressional Democrats have put forward sizable spending proposals, particularly the American Families Plan. When politicians boost spending, revenue needs to be raised.
That’s often easier said than done, and revenue-raising conversations on Capitol Hill often lead to talk about tax increases. Politicians will also often examine closing loopholes that advantage certain asset classes, including real estate investment trusts (REITs).
As experienced investors know, REITs are a tax-advantaged asset class. As long as the company doles out 90% of earnings in the form of dividends, it avoids paying corporate taxes. While that could be viewed as a bona fide loophole, the Biden Administration’s spending ambitions may ultimately prove to not be punitive to REIT investors and the related exchange traded funds.
“While the Biden administration’s proposed elimination of the 1031 exchange to raise tax revenue to fund the American Families Plan has caused concern among many real estate investors, we believe that the impact to U.S. REITs will be very limited,” writes Morningstar analyst Kevin Brown. “Over the past several years, REITs have disposed of tens of billions in assets each quarter and yet only rarely used a 1031 exchange to avoid capital gains taxes.”
Understanding REIT’s Dividend Treatment
REITs are known as pass-through investment vehicles. Dividends delivered by these companies are subject to different treatment than the payouts investors receive from a regular corporation, say Apple (NASDAQ: AAPL) or General Mills (NYSE: GIS).
REIT dividends aren’t considered qualified income, meaning these payouts are usually taxed at the highest levels, but REITs still have avenues that benefit investors come tax time.
“Part of the dividend can be reclassified as capital gains and thus taxed at a significantly lower level. Therefore, if the REIT recognizes capital gains on dispositions, the taxes owed by the shareholder on the dividend payment received from the REIT falls,” adds Brown.
As Brown notes, the 1031 exchange lever isn’t one REITs pull with frequency. The companies usually do so when asset sales run so high that capital gains could exceed “the amount of the dividend payment that can be converted from ordinary income to capital gains income.”
Bottom line: even if the 1031 loophole closes and REITs and the related ETFs slide, the long-term impact is likely minimal. Any decline incurred by REITs could be an opportunity for investors to get involved with the asset class.
Well-known REIT ETFs include the ALPS Active REIT ETF (NASDAQ: REIT), Schwab US REIT ETF (NYSEArca: SCHH), and the Pacer Benchmark Data & Infrastructure Real Estate SCTR ETF (SRVR).
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