After months of being communicated through vague frameworks and political talking points, Republican tax reform proposals have finally been unveiled in legislative language. Earlier this month, H.R.1, the Tax Cuts and Jobs Act of 2017, was introduced in the House and moved quickly through committee to passage by the full House of Representatives on November 16. The Senate tax reform bill left the Finance Committee on the same day and, as this edition of the REIT Advisor went to press, awaits a vote from the full Senate. While it is still too early to say whether the bill will pass the Senate or how the differences between the two chambers’ versions will be reconciled if it does, seeing actual statutory language has helped to clarify what tax reform will and will not mean for REITs.

Big Changes to Tax Economics of REITs and C Corporations

Two of the three central goals of this Republican tax reform push have always been a reduction in the C corporation tax rate and a lower rate on passthrough business income. (The third is international tax reform, which is less relevant for many REITs.) Both of these ideas figure prominently in both the House and Senate bills. Both bills reduce the maximum C corporation tax rate to 20%, while leaving the 20% tax rate on qualified dividend income of individuals unchanged. In the House version, passthrough business income would be subject to a maximum 25% rate (subject to certain exceptions and limitations), while in the Senate version, such income would attract a 17.4% deduction, which equates to a 31.8% maximum rate. The good news for REITs is that both proposals will treat ordinary REIT dividends as passthrough income subject to the new lower rates. This treatment means that REITs will not lose ground from a tax economics perspective when compared with other passthrough formats.

The reduction of the corporate tax rate to 20% makes the “no corporate tax” feature of REITs less beneficial than before. Under both bills, the combined corporate and shareholder income tax rate for a C corporation structure will be 36%.¹ Under the House bill, ordinary REIT dividend income would be taxed to noncorporate shareholders at a maximum rate of 25%, which still gives REIT structures a healthy tax advantage. Under the Senate bill, though, the maximum effective individual tax rate on ordinary REIT income would be 31.8%,² perilously close to the 36% C corporation rate. For businesses that struggle to abide by the strictures of section 856, operating in a REIT structure could become less attractive under the Senate’s version of tax reform. (Long-term capital gains earned by REITs would continue to enjoy favorable tax treatment compared to similar gains of C corporations under both proposals.)

The Senate bill also includes an intriguing hint that further moves towards corporate tax integration could be under consideration. The Senate bill would add a new section 242 to the Internal Revenue Code, which would allow a dividends paid deduction to all domestic corporations for distributions of post-2018 earnings and profits. Curiously, the amount of the deduction is currently pegged at zero percent of the amount of those distributions. This language is clearly a placeholder for further moves in the direction of corporate tax integration, which could come during further debates around the Tax Cuts and Jobs Act or could be the subject of later legislative pushes. REITs, of course, already enjoy a 100% dividends paid deduction.

Most Other Tax Reform Initiatives Neither Help Nor Harm REITs

Apart from the headline rate changes, many of the other business tax changes contemplated by the Tax Cuts and Jobs Act seem likely to have little direct impact on REITs. Section 1031 repeal, which has long been of concern to REITs and others, is addressed in both bills, but only in a limited form that will not affect real property exchanges. New limits on the deductibility of interest will generally not apply to the real-estate-focused businesses to which equity REITs are restricted. Immediate expensing of investments, another longstanding theme of tax reform proposals, will also generally not apply to real estate businesses.³ While REITs will obviously see no direct benefit from provisions that do not affect them, many in the REIT industry had previously worried that the major structural changes to the tax system being pursued could have harmful side effects for REITs, even if they were intended to be favorable to regular C corporations. But the tax benefits of REITs relative to C corporations continue to be substantial.

The Future of Tax Reform Remains Murky

The Senate proposal has not been approved by that chamber, and, at the time of writing, it is not clear if further changes will be needed to pass the bill. Even if it does pass, the numerous differences in the two competing proposals would need to be reconciled. The most that can be said with complete confidence is that the tax code will either stay the same or it will change. If it does change, though, the broad outlines seem to be that REITs will benefit from a passthrough rate reduction, but will otherwise be largely insulated from the big changes that will affect other taxpayers.