Even as concerns mount that the long period of economic growth we’ve enjoyed in the U.S. is starting to slow, the real estate market — both residential and commercial — continues to expand on a nationwide basis. The upward trend in real estate volume and value, combined with the sense of lingering uncertainty about how long the good times can last and some tax law changes introduced by the Tax Cuts and Jobs Act, have created a perfect storm for investors in real estate investment trusts.

REITs are collective funds that allow investors to pool their capital and make diversified investments in real estate by purchasing shares of a real estate trust. Because these investments are fractional and completely liquid, they offer a lower-risk alternative for investors to get exposure to the real estate market without actually buying physical property.

In the last few years, REITs have gotten even more popular thanks to new incentives created by the TCJA.

The passive investment

REITs are nothing new. They were created in 1960 as part of the Cigar Excise Tax Extension of 1960, as Congress sought to give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate. And that’s exactly what their creation did.

Small investors flocked in, thanks in part to an IRS provision that requires a REIT to return a minimum of 90 percent of its taxable income back to shareholders each year. A low-cost investment that is virtually guaranteed to give something tangible back at the end of the year? The concept sold itself, and REITs now account for approximately $3 trillion in gross real estate assets.

But when lawmakers amended the Tax Code in 2017, the allure of REITs ramped up even further. According to a Nareit analysis of Morningstar Direct data, in 2003, the share of all target-date funds with REIT exposure was only 50 percent. By 2018, 97 percent of these funds were invested in REITs.

The new benefits

So just what about reform led to this surge in activity? Sec. 199A of the TCJA, also known as the qualified business income deduction, had a lot to do with it. When applied to REIT investors, the QBI deduction consists of two components: the QBI component and the REIT/publicly traded partnership component. Investors can deduct the lesser of the QBI component plus the REIT/PTP component, or 20 percent of the taxpayer’s taxable income minus net capital gain. Because the majority of REIT distributions will be classified as qualified REIT dividends, REITs might provide a higher deduction than could be obtained through direct ownership of real estate, particularly for high income payers.

In addition, the burden of proof for meeting these tax deduction requirements with a REIT investment is fairly straightforward. Simply by owning a REIT, the investor qualifies. In contrast, if traditional real estate investors want to qualify for the QBI deduction, they must prove the income they plan to deduct is from a qualified trade or business. To take advantage of a beneficial safe harbor, the property’s owner must meet rigorous requirements, including a mandate that at least 250 hours be spent in the calendar year managing the property.

The home stretch

The tax advantages of REITs, coupled with the opportunity to diversify a portfolio, certainly create an attractive combination. However, before investors buy in, it’s important that tax professionals understand both the intricacies of the QBI deduction and ensure a REIT is aligned with the client’s investment goals.

In addition to the usual investment questions — how diversified are the properties, is management experienced, what’s the dividend history, is the REIT highly leveraged — they’ll have to understand the tax nuances to make sure it’s the right addition to their portfolio.