Why planners should reconsider REITs for HNW clients

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In recent years, financial planners have often recommended high-net-worth clients own real estate investment trusts in tax-advantaged retirement accounts.

That’s because dividends from these high-yielding investments did not qualify for the lower long-term capital gains tax rate that’s allowed for most other equities. Instead, dividends from REITs have been taxed as ordinary income, which meant paying taxes on them at an investor’s highest marginal rate, which can run close to 40% for high-income clients.

All of this changed, however, with the Tax Cuts and Jobs Act of 2017.

Under the law, investors, estates and trusts can now deduct up to 20% of their REIT dividends as a qualified business income deduction.

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Thus, in 2018, the effective tax rate on qualified REIT dividends for those in the highest income tax bracket will fall to 29.6% from 37%, the new highest marginal tax rate. REIT owners in lower tax brackets are eligible for this 20% deduction as well.

For high-income clients, this narrows (but doesn’t eliminate) the gap between REIT dividend tax rates and those on most non-REIT stock dividends, making REITs far more attractive for taxable accounts than in past years.

A place in many portfolios: REITs have long been known for paying healthy dividends. In June, the average annualized yield for REITs trading in the U.S. was 4.3%, with a comparatively low correlation to other investment assets. This isn’t anything new. The average REIT yield has been higher than 3.7% nearly 90% of the time since 1972.

The new 20% cut on REIT dividends came as a result of the tax break afforded to pass-through entities — partnerships, S corporations, limited liability companies and sole proprietorships that pass income through to clients' tax returns. These profits are taxed at individual rates and REITs are included in this investment category.

Of course, advisors and their clients should never solely focus on taxes when choosing an asset. But if they’d like to gain tax-advantaged income and real estate exposure in their investment portfolios, it may be a good time to take a look at REITs.

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