Quick Take: Private real estate investments offer tax advantages for income investors. Certain real estate funds offer tax-advantaged strategies such as the pass-through of real estate depreciation, and the deferral and elimination of federal capital gains taxes. The multiple strategies that are available align investments with long-term financial goals.
When performing due diligence on a potential investment, the main question investors should ask themselves is: “How much money is actually staying in my pocket?”
A portfolio of mutual funds and ETFs with a 10% dividend yield looks great on paper. But depending on the products’ investment profiles, investors could be subject to income tax liability throughout their investment horizon.
Higher-yielding investments could help compensate for the taxes that will be owed. But this could require income-focused investors to take on more risk than they’re comfortable with. In this article, we’ll explore how a private real estate investment can offer a more tax-efficient solution—with the potential for stable, consistent risk-adjusted cash flow as well as depreciation.
The Value of Depreciation
An important tax strategy in real estate investing is the ability to deduct depreciation throughout a property’s useful life. The aging of a property allows owners to use a tax deduction to recapture any loss of value and wear and tear incurred over time. The depreciated value can be deducted at tax time from the income received throughout the year. That, in turn, lowers overall pre-tax income. If a property is held by a fund structured like a partnership, the depreciation flows through to the fund’s investors.
If property is held by a fund that is taxed as a corporation—such as a REIT—the REIT can utilize depreciation to lower its taxable income. That may allow it to make distributions that are treated as a tax-free return of capital. The amount of taxable income distributed by the REIT is ordinary income to investors. And investors are eligible to deduct up to 20% of distributions treated as ordinary income.
The Tax Advantage of a REIT Structure
REITs can offer additional tax efficiency under the Tax Cuts and Jobs Act, which allows an investor to deduct up to 20% of a REIT’s ordinary income distributions from their taxable income. As an example of REIT efficiency, let’s look at a hypothetical investor with two investments. In one, $100,000 is invested in a mutual fund with an 8% net distribution yield. In another, $100,000 is invested in Origin’s IncomePlus Fund, which has a 6.5% net dividend yield and is structured as a REIT. The mutual fund portfolio consists of traditional securities. So the full income amount is subject to the investor’s tax bracket-in this case, 37%.
The amount of a REIT’s total distribution that can be classified as return of capital varies year to year and stems from the source of the REIT’s income to investors. Here’s how the two investments compare over the course of a year in which 98% of the Fund’s distributions are treated as a return of capital.1
The mutual fund pays $1,500 more in pre-tax dividends. But assuming an investor is subject to the highest income tax bracket (37%), the IncomePlus Fund can result in a higher effective post-tax yield.2
Evaluating a Tax-Equivalent Yield
The above example demonstrates the impact that taxes have on an investment’s effective distribution yield. This leads us to the idea of tax-equivalent yield: the return that a taxable investment needs in order to equal the yield on a comparable tax-exempt bond, such as a municipal bond. Although the standard definition references fixed-income instruments, the equation can be applied when comparing real estate investments versus non-tangible, traditional securities.
Here’s the formula for finding a tax-equivalent yield:
Using the example above, if an investor wanted to target a post-tax yield of about 8%, they would need to invest in an instrument yielding approximately 12.7%. If they wanted to achieve a post-tax yield of 6.5%, they would need to invest in a vehicle with a yield of 10.3%.
After-Tax Power of QOZs and 1031 Exchanges
Alongside depreciation, other investment strategies can enhance an investor’s post-tax yield. By investing capital gains in a Qualified Opportunity Zone fund, an investor can defer the initial tax owed until 2027. And if they hold the investment for at least 10 years, they can exclude taxes on future gains on the QOZ investment. QOZ managers will often choose to accelerate depreciation and employ cost segregation to take full advantage of real estate’s depreciation capability. With the elimination of all investment gains, including depreciation recapture, this effectively supercharges an investor’s overall return following the disposition of their investment. And it can provide significant depreciation sheltered income throughout the investment horizon.
Some investors with an investment property to sell may choose to undertake a 1031 exchange. This way, they defer all taxes associated with the property sale and benefit from income sheltered by depreciation. That said, investors should evaluate a 1031 exchange and a QOZ to see which strategy best suits their situations.
Ultimately, understanding how taxes impact investments is essential to making informed, strategic investment decisions that align with long-term goals.
- Targeted performance doesn’t represent an actual investment and frequently has sharp differences from actual returns. Targeted returns are inclusive of appreciation and reinvestment of distributions and are net of fees. There can be no assurance that the Fund will achieve comparable results or meet its target returns.
- The return of capital will also reduce the investor’s basis.
