REITs In 2018: The Impact Of Tax Reform

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Includes: DRA, DRN, DRV, FREL, FRI, IARAX, ICF, IYR, JRS, KBWY, LRET, NRO, PSR, REK, RFI, RIF, RIT, RNP, RORE, RQI, RWR, SCHH, SRS, URE, USRT, VNQ, WREI, XLRE
by: John Engle
Summary

REITs are impacted by a number of changes in the new tax law.

Changes to the treatment of pass-through entities, interest deductions, partnership terminations, and expensing all provide benefits to REITs.

A range of beneficial credits and deductions already in use have also been preserved.

The law will likely spur further investment in real estate, including REITs.

The changes are not so great as to change the outlook for the sector in 2018 and REITs will likely remain in a defensive posture.

The last time an omnibus tax reform passed into law, it was not a good day for the REIT sector. The Tax Reform Act of 1986 did many things to simplify the tax code, but it also placed strict limitations on loss deductions from passive investment activity, in addition to other restrictions that took away some of the tax perks of investing in REITs.

Thankfully for the REIT investors of today, history has not repeated itself. Rather, the Tax Cuts and Jobs Act, which was finally approved by Congress on December 20th, looks set to benefit REITs of all stripes.

Let’s take a look at the new law and see what has changed, what has stayed the same, and how it all impacts the outlook for REITs in 2018.

New Boons Granted

Many of the changes to the tax code will affect all real estate investment, not just REITs. I have written already how new pass-through deductions will benefit property investors. REITs will share these benefits, including the 20% deduction on income from pass-through entities – a standard REIT corporate structure. And while there are many businesses and industries that make wide use pass-through structures, REITs get special treatment. Specifically, businesses using the pass-through deduction have a cap on the amount they can deduct, based on wages paid by the business and by value of property acquisitions. REIT dividends have been excluded from the wage restriction, fortunately for income investors.

REITs also benefit from an exception carved out in the new rules concerning business interest deductions. While most taxpayers will not be able to deduct business interest expenses beyond 30% of EBITDA, REITs are able to opt out of new rule. However, opting out comes at the price of a longer cost recovery period for property. The longer depreciation schedule will frequently prove to be well worth accepting if it means avoiding the 30% EBITDA cap.

A final interesting benefit worth noting that will be of especial interest to REITs is the repeal of the rule stating that partnerships would be terminated if 50% or more of the interests in its profits and capital were sold or exchanged within a one-year period. This gives REIT firms a degree of greater flexibility and stability that the old rule could occasionally threaten.

Many Blessings Sustained

There are a few benefits that REITs have enjoyed under the previous law that have been preserved in the new tax regime. State and local tax deductions have been preserved for pass-through entities, such as REITs, that accrue those liabilities through the conduct of business that generates income. Thus REITs are protected from caps on local deductions that will affect, among other things, homeowners.

Credits for low-income housing and for preservation and rehabbing historic buildings have also been retained, though the latter is now more restrictive than under previous law.

Outlook 2018

Overall, the impact of tax reform on the REIT sector can be called positive. There is no earth-shattering change that will transform the industry, but REITs will benefit from the range of new provisions and deductions, and investors will no doubt be taking note as we pass into 2018.

The REIT industry itself is unlikely to shift its apparent focus on consolidation and refinancing over new acquisitions. We remain in a bull market that is quite long in the tooth, and REIT operators are well aware of the risks of making purchases when property prices continue to test new highs. Any financial windfalls or advantages emerging from the tax reform will likely see more deployment in M&A among REITs than to new properties.

REITs will undoubtedly benefit from the new tax reform, but the advantages will likely be put to use to bolster the prevailing conservative attitude within the industry rather than alter it meaningfully.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.