A Qualified Opportunity Zone (QOZ) investment is one of the most tax-efficient real estate investments you can make. If you are considering investing in a QOZ, you are probably evaluating several different options, including the investment’s legal framework. Is it structured as a real estate investment trust (REIT) or as a partnership such as a limited liability corporation (LLC)? It may seem odd to begin the evaluation process here, but this choice alone could affect your tax planning and overall return on your investment.
At Origin, we employ both REITs and partnerships, depending on which one offers the most benefit to our investors. Our IncomePlus Fund, for instance, has a REIT subsidiary structure, while our QOZ Fund II is structured as an LLC and taxed as a partnership. Both REITs and partnerships such as LLCs allow individuals to invest in portfolios of real estate, but there are nuances to each that make one more suitable for certain investments than the other.
Tax Structures of REITs and LLCs
A REIT generally has a more favorable tax structure when taxable income is generated. Under the 2017 Tax Cuts and Jobs Act, REIT investors can take a deduction equal to 20% of qualified dividends, effectively reducing the highest applicable tax rate to 29.6% from 37%. A REIT also can utilize the benefit of depreciation. And in some cases, all or part of a dividend may be treated as a nontaxable return of capital.
The advantage of a partnership is that depreciation and other operating expenses are passed through to each investor. The losses these expenses create may equal more than what is necessary to shield the income generated by the partnership’s investments. The investor can use these “excess losses” to shield other passive income on their tax return. If the excess losses aren’t used, they can be carried forward.
When it comes to the cost of filing annual taxes, a REIT has an advantage over an LLC, and for smaller investors, this could be material. Because the REIT is treated as a corporation, it issues a Form 1099 to its investors. This makes tax preparation for REIT dividends straightforward. Investors receive a single 1099 statement and only pay income tax in the state where they reside, even if the REIT has property in multiple states.
A partnership works differently. Because it’s considered a pass-through entity, if the partnership owns investments in multiple states, so does the investor. That means investors must file a Schedule K-1 in each state with a personal income tax. To ease the costs and burden on investors, most fund managers allow a composite election, so only one K-1 must be filed.
How REITs and LLCs Operate in a QOZ Investment
One consequence of investing in a QOZ fund, whether it’s a REIT or a partnership, is that your tax basis in your investment is zero. If you’re not an accountant, this may not sound important, but it can have a material impact on the timing and taxation of distributions you may receive from the QOZ fund.
In a partnership, debt is allocated among the partners and adds to each partner’s basis. Distributions of refinancing proceeds therefore generally are treated as a tax-free return of equity because the distribution does not exceed the basis. In a REIT, however, debt is not allocated to the members, and if a member’s basis is zero, any distribution will be taxed.
Let’s say a multifamily ground-up development project is structured as an LLC and is part of a QOZ investment. It’s capitalized with $50 million of debt and $20 million of equity. If an individual invests $1 million of capital gains into this project, they will own 5% of the project ($1 million out of $20 million). While no basis is assigned to the $1 million investment, the investor will be assigned their proportionate share of the debt proceeds, which creates basis of $2.5 million, or 5% of $50 million. This basis will allow the fund to make distributions to the investor without triggering a taxable event.
However, if that scenario were repeated within a REIT structure, the debt would not be allocated to the investor. Therefore, an event that would be nontaxable in a partnership becomes taxable. Investors in any QOZ fund, regardless of its structure, will establish basis in their investment at the end of the tax deferral period on December 31, 2026. If the REIT does not plan to return any capital prior to 2027, the issue of basis is immaterial. That’s because once the individual pays their taxes in 2027, the invested dollars will be assigned a basis and distributions not exceeding basis can be made tax-free.
Proposed Legislation Would Extend Deferral Period
Legislation proposed in early May would, if enacted, extend the deferral period of an QOZ fund to 2028. That means investors in a QOZ fund structured as a REIT would have to wait an additional two years before any distributions could be made without tax consequences. This extension could place additional burdens on REITS, which are required to distribute 90% of taxable income or pay taxes at the REIT level.
If, prior to the expiration of the deferral period (whether that’s at the end of 2026 or 2028) a REIT has generated taxable income, it faces a dilemma: Make a taxable distribution to investors or retain the income and pay corporate tax on the amount retained. Either option diminishes the return to an investor. We believe the ability of a partnership to create basis and tax-free distributions from debt financing offers a strategic advantage over a REIT. The receipt of a partnership K-1 might cost another $75 to file each year, but we believe that the benefit of creating basis and allowing for tax-free distributions during the tax deferral period outweighs that modest additional cost.
How We Help Investors Navigate QOZ Fund Investments
At Origin, we understand the complexity of Opportunity Zone investing and have tremendous experience in structuring Funds that help our investors make the most tax-efficient returns possible. Our goal in our QOZ Fund II is to return 30% or more of invested capital to our investors prior to 2027 so they can pay their taxes.
No single legal structure works equally well in all situations. We employ a variety of them in our Funds, so that in each case, our investors can earn the most tax-efficient returns possible. No matter what kind of real estate investment you’re considering, it’s helpful to understand the pros and cons of each structure and how it can impact your tax responsibilities and returns.