Taxes- Comparing REITs and Direct Investment
Every person who invests in well-selected real estate in a growing section of a prosperous community adopts the surest and safest method of becoming independent, for real estate is the basis of wealth.
-- Theodore Roosevelt, 26th President of the United States
Since the inception of the United States government, citizens have been granted (and encouraged) to exercise the right to own real estate. In the 1800’s, the Homestead Acts were designed to encourage people to take ownership and care for the land that represented the United States of America. Interestingly enough, more than 270 million acres of public land (over 14% of the contiguous United States) was given away for free to ensure that the land belonged to the people [1]. This notion of encouraging citizens to own real estate is still present today as evidenced in the favorable tax laws surrounding property ownership.
For investors not interested in owning, operating, and fulfilling all of the compliance regulations that come with owning business-purpose real estate, the two most popular investment options for obtaining real estate exposure in one’s portfolio are REITs and private equity partnerships (later referred to as “PEPs”). Let’s take a closer look at what these two investments usually look like.
REITs
REITs (which stands for Real Estate Investment Trusts) are publicly traded equities which grant its owner a share in a real estate fund. This fund is similar in function to an exchange traded fund (ETF) in that an investor can obtain the economic benefit of owning their proportionate share of several (perhaps even hundreds) of real estate properties by investing a relatively small amount in purchasing shares of the REIT. The obvious benefit to owning a REIT is that each dollar invested is exposed to the benefits of owning, for example, a multi-family property in Dallas, commercial property in Kansas City, or perhaps retail space in Burbank without the investor having to search, purchase, and maintain the properties themselves. The REIT’s positive operational cash flows are paid to the owners in the form of dividends that are usually taxed as ordinary income.
Private Equity Partnerships
Private equity partnerships are exactly what their namesake alludes to – private. That is, they’re not listed on a public exchange and are usually not bought into and out of except at the inception and dissolution of the fund. They are similar to REITs in that they provide investors a means to invest in real estate without the burden of management and oversight. The partnership will purchase a property or set of properties, and pass through operational cash flows to the owners in the form of nontaxable distributions. These partnerships are considered “flow-through” entities for tax purposes and thus funnel all income and expenses to its partners at their pro rata ownership level.
Now that we have a general idea of the formation of these two different investment vehicles, the big question for investment advisers becomes, “which is best for my clients?” When mulling over the answer to this question, one of the greatest considerations (if not the greatest) needs to be the evaluation of tax liability to the investor. As you’ll see below, the tax implications in each scenario can be as different as black is to white.
In conclusion, the tax benefits of private equity partnerships typically far outweigh any tax benefits associated with REITs. In most situations, PEPs are better able to capture the varying tax benefits of owning real estate. However, it is important to recognize that each investor’s tax situation is unique and could fall outside the realm of these general tax assumptions. Thus, this paper is not meant to provide specific tax advice, but rather a general idea of the pros and cons of each investment vehicle.
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1. https://en.wikipedia.org/wiki/Homestead_Acts
