Many of us in retirement invest for long term reliable dividends from the stocks we hold. If any of these dividend paying stocks are REITs and are held in a taxable account, there will likely be a nice bonus at tax time. Under the Tax Cuts and Jobs Act (TCJA) of 2017, those business entities that “pass-through” the business’s taxable operational earnings to the shareholders or partners, are going to be able to deduct 20% of those earnings that are taxed to the shareholder as ordinary income. This will apply to such pass-through entities as S-Corporations, Partnerships (of all types), pass-through LLCs, proprietorships and yes, REITs. Most of the chatter on this new deduction is centered on the business owners and the nice tax break many of them will receive. That’s great and I’m happy for them…but I’m not a business owner, I’m retired and own a portfolio of equity and some mortgage REIT preferred stock, and so my interest in this new deduction begins and ends with REIT shares, so that is what I will focus on here. However, a quirk in the new tax code is this deduction, it would seem, will not apply to the REIT dividends passed through by mutual funds, to include open end, closed end and ETFs. I cannot confirm this, but it is what I’ve read from several different sources.
Section 199A deals with this deduction, and so that part of the REIT dividend that is deductible will be referred to as the “199A dividend” or sometimes as REIT Qualified Business Income (QBI), but to avoid confusion, I’ll refer to it the way the 1099-DIV does as the 199A dividend. The new rule requires the REIT to differentiate how much of their distribution, if any, will qualify as a 199A dividend. As I previously mentioned, this must be the actual operational income of the REIT. It must exclude any capital gains, any interest, any qualified dividends (these are taxed separately if part of the dividend) and any Non-Dividend Distributions, also referred to as Return of Capital (ROC). This will be reported in 2019 for 2018 on a new form 1099-DIV, in box 5
The amount in box 5 will then be multiplied by 20% and that amount will be taken as a deduction. If the proposed form 1040 is adopted, this deduction amount will be entered on line 9 to be subtracted, along with the greater of the taxpayer’s itemized or standard deduction, from the Adjusted Gross Income (AGI), to then arrive at the taxpayer’s taxable income. Although I’m sure this will be rare, but this deduction is limited to the lesser of 20% of 199A dividends or 20% of the household’s taxable income AFTER subtracting out any net capital gains. The only way I can imagine this happening in a retired household is if there is some very large itemized deduction or the household just retired, has not started Social Security or a pension and derived the first year’s income by selling some highly appreciated capital asset, such as a rental house….and in such cases the household also had large 199A dividends. So as I say, this will be rare.
The good news is one does not have to itemize deductions to take the 199A deduction and there is no AGI phase-out (note, there is an AGI phase out for service-related business owners to be able to deduct the REIT 199A dividend). Other good news is this applies to common and preferred shares as well as to equity REITs and Mortgage REITs. The not-good news is this deduction does not reduce AGI and so will have no effect on AGI-calculated surtaxes such as the Net Investment Income Tax, taxability of Social Security, Affordable Care Act subsidies or the Income Related Monthly Adjustment Amount (IRMAA) Medicare surtax. Also, this deduction applies only to REIT dividends in a taxable account and will not apply to REITs held in tax deferred/tax free accounts such as IRAs. But the real not-so-good news for those households that also hold MLPs, the combined REIT 199A dividends must be combined with the 199A distributions from all MLPs held. Many (most?) MLPs have negative earnings as shown in box 1 of the K-1. Per Jeffrey Levine’s article…
In instances where clients own both REITs and PTPs, negative qualified PTP income may reduce, or eliminate, any QBI deduction that would have otherwise been available for the qualified REIT dividends.
And to add a bit of insult to this potential injury, if the net of the REIT and MLP 199A dividend is negative, that negative value must be carried forward and used in future year 199A deduction calculations! Bummer!!
But let’s get back to the household whose pass through income is only from REITs. How can we estimate the 199A deduction for the REIT dividends received in 2018 in a taxable account? If we can do so relatively reliably, perhaps we could use this to fine-tune our quarterly estimated tax payments to the IRS although some might consider this, at least for the first year, to be a bit risky to be used in calculating quarterly estimated payments….myself being one of those. But at least it would certainly be nice to get some idea how much this will reduce our 2018 tax bill. Unfortunately, the REIT Investor Relations offices I’ve spoken to cannot project what their 1099-DIV box 1a amounts will be for 2018, and this is understandable. But we can calculate it for 2017 as a rough guide to what it may be in 2018. Here is the method I’m using.
I currently hold 24 REIT common and preferred stock. Generally, preferred stock will provide the greatest amount of box 1a ordinary income, as the preferred shares are paid first with the REITs earnings. For my illustration here, I’m going to reduce this number to 3 equity and 3 preferred REIT shares to keep it simple.
Here, I’m assuming I have 1,000 shares of each REIT just to use round numbers. I got the 1099-DIV data from the NAREIT web site, where you click on “REIT Data” and then on “REIT Market Data” and then scroll down to “Year End Tax Reporting Data”. Make sure the data are for 2017 and then go, by alphabet, to the REIT in question and it will take you to the 1099-DIV data. Another method I’ve found to work well is to simply type something like “NHI 2017 1099-DIV” into the Google search page and it will generally take you directly to a link to the company’s 1099-DIV. The first data you need to enter is the total “Shareholder’s Income”, which will be the gross dividend paid for that year. Note, do not add up the quarterly dividends you’ve received for the year, as late year timing adjustments can, for tax purposes, kick a dividend into the next year. The next number is the box 1a Total Ordinary Dividend which is that part of the dividend that represents part or all of the REIT’s ordinary income. The next value in box 1b, if any (and this is unusual for most REITs) is the part of this ordinary dividend in 1a that is a ‘Qualified Dividend’, which represents earnings the REIT paid tax on. These do not qualify as QBI and are taxed separately by the shareholder. Because they are part of the dividend’s ordinary income, the amount, if any, shown in box 1b must be subtracted from the amount in box 1a. What remains I’ll refer to as the adjusted ordinary income which represents the pass-through ordinary income to the shareholder taxed at the shareholder’s tax rate, which for most retirees will be the 12% or 22% rate. For most REITs, box 1a will be smaller than the total dividend because there are other tax character components of the dividend, to include capital gains (including possible Section 1250 unrecaptured gain) and Return of Capital. However, I don’t concern myself with these in calculating the 199A dividend, as they cannot be part of it.
In the example I’ve shown, my assumption is these shares have been held for the full year. For partial year holdings, either due to purchasing shares or selling of shares during the year, the same process can be done using reported quarterly dividend data, with separate lines for each quarterly dividend, but the calculation as shown above will remain the same.
I then multiply the per-share adjusted ordinary income part of the dividend for each REIT for 2017 by the number of shares I hold and then total all REITs and multiply this total by 20%. Now, this is where things might get a bit tricky. The two Investor Relations reps I spoke with at Realty Income and Tanger said they are assuming 100% of the adjusted ordinary income will be QBI. Sec. 199A makes clear that only that part of a pass through adjusted ordinary income that represents income from business operations may be counted, and this may exclude things like interest, dividends or damage settlements in excess of the cost of damage, to name a few. But I’d imagine these are going to be very small and may be lost in rounding. So my assumption here is 100% of adjusted ordinary income will qualify for the 199A deduction.
So in this example, I would take a $3,111 deduction from AGI. Unfortunately, this would be accurate for 2017 but will almost certainly not be the amount for 2018 even if all dividend total amounts remained constant, as the tax character of the components of the dividend will almost certainly change. However, it does give the household a ball-park estimate of what the 2018 deduction will be. It will be interesting to see how close this estimate will be to the actual total 199A dividends that will show up in the summary 2018 1099-DIV Box 5 I’ll get next March.
Disclosure: I am/we are long CBL.PD, EQC.PD, CLNS.PD, EPR, NHI, SPG. 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.