Do REITs offer tax advantages?

Some REIT promoters love to talk about the tax advantages of REITs.  In particular, they focus on the ability of REITs to avoid paying income tax provided they meet the requirements of 26 U.S. Code § 856.

At face value, the avoidance of corporate tax would appear to confer a significant advantage to an investment in a REIT compared to an investment in a corporation that is subject to corporate income tax:

Fig. 1:

REIT Taxable Co.
Pretax Income 1,000 1,000
Income Tax 0 350
Net Income 1,000 650

The two companies achieve the same pretax income, but the net income of the REIT is significantly greater strictly because the REIT does not pay corporate income tax.  The taxable company would have to grow substantially to overcome the REIT’s tax advantage, by more than 50%!

Now let’s consider the story from the perspective of the investor. The analysis depends entirely on the tax situation of the investor.  Let’s see what a worst-case scenario (for the REIT) might look like, using the tax tables found here.  REIT distributions of income may be taxed at ordinary income tax rates. Qualified dividends distributed by a corporation may qualify for a lower tax rate:

Fig. 2:

Investor … REIT Taxable Co.
Dividend Income 1,000 650
Income Tax Rate 39.6% 23.8%
Income Tax 396 155
Income After Tax 604 495

The REIT still has an advantage over the taxable company, although not as much.  The taxable company need only grow by 22% in order to generate as much after-tax dividend income for the investor.

Of course, were the investor to invest in REITs using a tax-deferred account such as an individual retirement account, he could ignore the second table (Fig. 2) altogether, as the economics of Fig. 1 would apply.

As always, this is not tax advice and you should obtain the help of a qualified tax professional.