Originally published on Forbes.com.
Real Estate Investment Trusts (REIT) and Publicly Traded Partnerships (PTP) get special treatment in the Tax Cuts And Jobs Act (TCJA)- Sorry I just can’t call it tax reform. Maybe tax deform, but that sounds silly. TCJA repealed Section 199, a kind of freebie 9% deduction, that created a frenzy of gaming in somewhat limited circles – Brewing coffee is manufacturing. I mean who knew? -and replaced it with a much broader 20% deduction (Section 199A). To qualify for the deduction your trade or business has to be paying people W-2 wages or have depreciable assets if your taxable income exceeds a threshold. REIT dividends and PTP flow-through income get the 20% deduction with no strings.
The Object Of The Game
If the gaming involved in Section 199A were done on a board, it might not ace out Chess or Go or Scrabble , but it would definitely be more popular than euro classics like Settler of Catan and Ticket to Ride. I’ve already written at some length on the topic so I will give you a quick executive summary. Below taxable income of $207,500 for a single, double that for a married couple filing jointly, there is some benefit for anybody with trade or business income (i.e. income not from employment or investment). The unlimited benefit begins phasing out at $157,500 for singles and $315,000 for married joint.
Above the phase-out it gets more complicated. First there is as President Trump would say the s— list. That would be “performance of services that consist of investing and investment management, trading, or dealing in securities” and”performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners”. That last one – nobody knows what it means.
And then there is the W-2 requirement. Your deduction is the lesser of 20% of the net from a trade or business or 50% of the W-2 wages paid by that business. An alternative test is 25% of W-2 wages paid plus 2.5% of the unadjusted basis of depreciable assets.
REITs And MLPs – Get Out Of Jail Free
There is a whole other category of income that qualifies for the 20% deduction – pretty much with no strings attached – “20 percent of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income.”
REITs are real estate investment trusts. A REIT is taxed as a corporation, but if it has the right mix of income, it can deduct the dividends that it pays to its shareholders. The shareholders get ordinary income from those dividends unless they source to capital gains. Publically traded partnerships (sometimes referred to as master limited partnerships) are, well, partnerships. To not be reclassified as corporations, they need to have the right sort of income mix. They tend to concentrate in the energy area, but can have real estate.
A partnership flows income or loss to its partners regardless of distributions, but PTPs have a special rule. Any losses from a PTP are suspended and go into a bucket that can only be used against income from that particular PTP or freed up when the interest is disposed of. Tax preparers hate PTPs. Don’t get me started.
So Where Is The Break?
PTPs and REITs provide a similar tax result to outright ownership of a rental property or ownership through a non traded partnership. So there is logic in allowing the 20% deduction on REIT and PTP income. The break is that there is no W-2 or depreciable asset requirement. Tax preparers who deal with PTPs should be thankful for that small mercy.
Is There A Problem/Opportunity?
The problem/opportunity that I see is that you may get a different result from the same enterprise depending on what entity you have wrapped around it. A commercial real estate project that is light on depreciable assets will produce a better result inside a REIT or a PTP.
I tried to explore whether anybody is on to this. Fellow Forbes contributor Brad Thomas gave me some insight into the REIT space. Mr. Thomas has written about how great the TCJA is for commercial real estate.
For someone who loves Monopoly and lives and breathes real estate, I recognize the power that the deal-maker-in chief is getting ready to unleash for ALL Americans. It’s like getting a Monopoly card that reads “All American Voters Will Become Wealthy Again”.
Believe me. I don’t live in a left-wing bubble. Most of the Trump voters I know, however, explained it either in terms of abortion (Go figure) or “What about her emails?”. Mr Thomas’s giddiness about President Trump was breathtaking. He told me that he went to Trump rallies to get energized. I went to one and was rather disturbed. De gustibus non est disputandum.
An interesting side-note in Mr. Thomas’s article is that he credits Julio Gonzalez with keeping Code Section 1031 (like-kind exchange) in place for real estate. I’d like to get more on that story, but I’m not making any promises.
Even though Mr. Thomas is exuberant about TCJA’s good news for REITs, I did not come away from our conversation with a sense that there will be a massive migration of real estate to the shelter of REITs.
My inquiries with people knowledgeable in the PTP (or MLP) area indicated that that industry wasn’t planning on coming out ahead. They were just hoping to stay even.
So my conclusion overall is that the clear advantage that REITs and PTPs have will probably not lead to a massive shift of assets to those vehicles.
How Did We Get There?
The House Bill which operated by giving a special rate rather than a deduction did not have a W-2 requirement. It penalized anybody who actually themselves worked in the business and the “you know” list. Depreciable assets could, however, mitigate the penalty of actually working in the business or being involved in one of those distasteful fields like health or, God forbid, accounting .
PTPs would be fine under the House Bill without any special mention and REIT dividends were also given the special rate. So under the House Bill PTPs and REITs were on the same footing as other passive vehicles or outright ownership.
Then came the Senate bill. It put in the W-2 requirement while retaining the special treatment for REIT dividends. It was disastrous for commercial real estates and PTPs since, for the most part, the properties don’t generate that much in the way of W-2 wages. The final bill put PTPs on the same footing as REITs and put in the 2.5% of depreciable basis alternative which would cover many, if not all commercial real estate enterprises (at least by my back of the envelope computations).
The 2.5% would also have covered PTPs to some extent, although I can’t even do back of the envelope on that. The big problem would have been compliance. PTPs with multiple businesses would have had to included information so that return preparers could work out the Section 199A deduction for each business. In right to carry states preparers who couldn’t shoot their clients who owned PTPs would shoot themselves. In the states with less reverence for the Second Amendment, preparers would sit at their desks and weep. In India, they would relish all the new business, as the US preparer ranks were decimated.
All in, it looks like the PTP lobbyists and the commercial real estate went to work and each found a Republican senator who hadn’t gotten a case of beer from taking care of the excise tax and both groups won.
All in it might be worth taking another look at REITs as an investment in the event the market has not already priced in the new benefit, Also consider MLPs. Just don’t ask me to do your return.