The 2017 Tax Cuts and Jobs Act (TCJA) brought sweeping changes to the American tax landscape. For investors in Real Estate Investment Trusts (REITs), particularly those in private mortgage REITs, the act has delivered a significant impact. One of the most advantageous elements of the TCJA for these investors is the indirect relief it provides from the Unrelated Business Income Tax (UBIT). Here’s an in-depth look at this transformational act and its effects on the unrelated business income tax deduction for private mortgage REIT investors.
The TCJA, passed at the end of 2017, is one of the most comprehensive tax reforms in recent U.S. history. While its primary intention was to boost economic growth through corporate tax rate reductions and various incentives for businesses, the act also brought consequential changes for real estate investors. A few key provisions include:
1- Lower Corporate Tax Rates: The TCJA decreased the corporate income tax rate from a top rate of 35% to a flat 21%. This pivotal change aimed to make the U.S. more competitive globally.
2- Interest Deduction Limitations: The TCJA imposed a cap on business interest deductions to 30% of adjusted taxable income for businesses with significant revenues. Notably, REITs were exempt from this limitation.
3- Net Operating Loss Adjustments: The new act modified how net operating losses (NOLs) can be carried forward and backward, affecting tax planning strategies for many businesses.
UBIT is a tax levied on tax-exempt entities, like charitable organizations or IRAs, for income they earn from business activities unrelated to their tax-exempt purposes. The principle behind UBIT is to prevent tax-exempt entities from unfairly competing with taxable businesses.
Income that might be subjected to UBIT includes that from a regularly conducted trade or business that is not substantially related to the tax-exempt entity’s primary purpose. Fortunately for investors, most passive income sources, such as dividends, certain rents, and interest, are not subject to UBIT.
Private mortgage REITs typically provide financing for real estate, earning income from the interest on the mortgages they hold. Before the TCJA, tax-exempt entities, such as IRAs or charitable organizations investing in REITs, might have encountered UBIT complications, especially if the REIT had properties acquired using debt financing.
1- REIT Dividend Deductions: One of the stand-out provisions of the TCJA for REIT investors is the introduction of the 20% qualified business income deduction. This allows individual investors to deduct up to 20% of their REIT dividends, which are treated as ordinary income. Although this benefit is more direct for individual taxpayers, it adds to the overall appeal and tax efficiency of investing in REITs.
2- REITs and Interest Deduction Limitation: As mentioned, the TCJA imposed limits on business interest deductions, but REITs are generally excluded from this limitation. This is particularly beneficial for private mortgage REITs, which are more likely to have significant interest income. Without this limitation, these REITs can operate more efficiently, potentially distributing higher dividends to investors.
3- Clarity on UBIT: The TCJA brought clarity, ensuring that returns from debt-financed properties in REIT structures don’t expose tax-exempt entities to UBIT. This means that tax-exempt investors in a private mortgage REIT can be more confident that their dividends won’t be subject to UBIT.
The 2017 Tax Cuts and Jobs Act, though primarily focused on stimulating economic growth, has inadvertently made private mortgage REITs a more attractive investment for tax-exempt entities. By alleviating concerns surrounding UBIT and providing clarity on certain deductions, the act has bolstered the case for including private mortgage REITs in a diversified investment portfolio. As with any investment decision, potential investors should consult with financial and tax professionals to understand the full implications of their choices.
Brock VandenBerg is the President of TaliMar Financial and Fund Manager of TaliMar Income Fund I. Mr. VandenBerg started investing in individual trust deeds in 2008, providing capital to real estate investors taking advantage on the housing crisis. He soon brought in outside investors to share in this lucrative opportunity to earn above market returns. After funding over $375 million in short-term loans and attracting over 500 investors, Mr. VandenBerg launched TaliMar Income Fund I in 2021 to offer investors a much more efficient way to invest in individual trust deeds. Currently, TaliMar Income Fund I invests on behalf of over 220 individual investors with over $60 million in assets under management.