Pass-through provision in new tax law could benefit REITs, MLPs

Investors in such instruments are likely to see substantial tax savings in the next few years

Jan 23, 2018 @ 1:56 pm

By Greg Iacurci

The new tax law will likely benefit investors in real estate investment trusts and master limited partnerships as a result of a particular tax break afforded to pass-through entities.

As such, advisers' clients who are invested in such instruments may see substantial tax savings over the next several years, and REITs and MLPs could look more attractive as investments.

"While this was really about benefiting businesses and business owners, it can spur on a few different types of investments," said Jamie Hopkins, associate professor of taxation at The American College of Financial Services.

Pass-through entities are those such as partnerships, limited liability companies, S corporations and sole proprietorships that pass their income through to owners' tax returns, so profits are taxed at the owners' individual rate.

The Republican tax bill, signed into law on Dec. 22, gives a 20% tax deduction to certain pass-through business income. Some categories of investments, such as REITs and publicly traded partnerships, including MLPs, get the tax break.

"That could be a significant deduction for some people," said Jeffrey Levine, CEO and director of financial planning at Blueprint Wealth Alliance.

(More: Oops! Unintended consequences of tax-law changes)

REITs and MLPs are popular because of their income-paying characteristics. Only the income counting as "business income" from such investments would qualify for the tax break, which is reported on a 1099 tax form for a REIT investor and on a K-1 for an MLP investor.

Let's say a REIT, for example, pays an investor $100. In this case, the investor may only need to pay tax on the $80 of that distribution that is classified as business income. And with lower marginal tax rates under the new law, which imposes a top rate of 37%, down from 39.6%, investors may pay less tax on that $80.

"If you're considering a REIT investment or partnership investment, this will perhaps make it a little more attractive to you," said Tim Steffen, director of advanced planning in the private wealth management group at Robert W. Baird & Co. "But if you haven't invested in these before, this shouldn't necessarily be the thing that pushes you over the edge to start investing in them now."

Tax experts say the financial windfall will vary from investment to investment. Further, Mr. Steffen said he's "fairly confident" that investors in REIT and MLP mutual funds wouldn't qualify for the tax break, but said it's not wholly clear.

While a determination of the tax benefit to REIT investors should be fairly simple, that to MLP investors will likely be particularly thorny, experts said.

Mr. Steffen believes the 20% deduction will provide a larger benefit to MLP investors in the year in which they sell their shares, as opposed to the years during which they hold the investment. That's a result of the unique way in which MLPs make distributions.

Most shareholder distributions are classified as a "return of capital," due to things such as depreciation on MLP holdings — so the distribution isn't counted as taxable income for the investor.

When an investor sells, though, there's a "recapture" process in which the investor pays income tax related to that depreciation, and this is where the pass-through provision could prove most valuable, Mr. Steffen said.

For example, let's say an investor buys one MLP share for $15. The MLP then pays $1 in distributions, which is counted as a "return of capital." Let's say 30% of that return of capital is attributable to depreciation. At time of sale, the investor would pay income tax on 30%, or 30 cents, and would pay capital gains tax on the remainder. That 30 cents is what would be eligible for the 20% pass-through tax break, experts said.

"You get to avoid income during years when you hold [the MLP], but you pick it up when you sell it. It's unique to MLPs," Mr. Steffen said.

Mr. Levine of Blueprint Wealth Alliance said these tax benefits could make REITs and MLPs more popular, in turn increasing their price and benefiting current investors. However, he questions whether such investments will benefit more under the tax law than corporate stock, given the much-lower 21% tax rate corporations now pay.

"Do MLPs benefit more than an Apple, Google or Microsoft? I don't know. Just because something is good doesn't necessarily mean something else isn't even better," Mr. Levine said.

(More: Tax reform: 7 essential strategies for financial advisers)

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