In addition to changing several aspects of the tax code, the Tax Cuts and Jobs Act created a new deduction. It appears on the 1040 right above taxable income and below your standard or itemized deductions. It is called the “Qualified Business Income Deduction” or QBI deduction. It is a deduction intended for businesses that are operated through a pass-through entity, meaning an entity whose taxable income is passed onto its owner’s personal return rather than filing its own return.

Examples of pass-through entities are businesses filed on Schedule C, such as sole proprietorship or single LLC, or on Schedule E, such as partnership or S corporation.

These entities, as the IRS reports, receive “up to 20 percent of qualified business income (QBI) from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust or estate” as a deduction. This deduction is limited if your taxable income exceeds $315,000 for a married couple filing a joint return or $157,500 for all other taxpayers.

There is another side to the QBI deduction as well. You are also allowed to deduct “up to 20 percent of their combined qualified real estate investment trust (REIT) dividends,” and this deduction is unlimited.

A REIT is a company which owns or finances real estate and passes its income on to its shareholders. You can invest in REITs on the stock market. (We do.)

REITs were created in 1960 by Congress to give all Americans a vehicle to own long term real estate investments. Along with this invention, they have put in place specific guidelines which REITs, unlike other stock market securities, must follow. The two biggest rules are:

First, over 75% of their value must be comprised of owning or financing real estate. Equity REITs own property and get their income from renting the properties. Mortgage REITs get their income from interest payments from financing properties.

Second, REITs must distribute more than 90% of their profits as dividends. As a result, REITs have a dividend yield which is higher than average. Currently, the dividend yield for Vanguard’s REIT ETF (VNQ) is 4.51% while the dividend yield for Vanguard’s S&P 500 ETF (VOO) is only 2.07%.

In exchange for abiding by these and other rules, the IRS does not require REITs to pay income taxes.

Now that the Tax Cuts and Jobs Act has passed, REIT owners are also allowed to deduct 20% of their dividend proceeds as a QBI deduction.

It begs the question that I was recently asked:

Can I deduct my normal real estate income or can I turn my real estate income into a REIT to get the QBI deduction?

Alas, even though real estate income is on Schedule E right next to many of these other pass-through entities, your standard real estate income has not been extended the benefit of the QBI deduction. This, in my view, is a sad discrimination. The whole intention of the REIT laws were to give poorer Americans a way to benefit from real estate investments. To exclude rental houses, the most common real estate investment that middle class Americans have, from the special tax treatment of the QBI deduction seems regressive.

That being said, the thought of trying to convert your real estate income to a REIT is sneaky but, sadly, basically impossible.

As REIT.com reports:

Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 shareholders (the 100 Shareholder Test) and five or fewer individuals cannot own more than 50 percent of the value of the REIT’s stock during the last half of its taxable year (the 5/50 Test).

This is just one of many requirements a REIT needs to pass, but this one alone is normally sufficient to prevent a standard rental house’s income from being able to be converted into a REIT. Sure, you could sell your real estate into a REIT in exchange for shares, but this might impoverish you more than the tax benefit would gain you.

This new REIT QBI deduction begs another question we were asked:

Should we overweight REIT in our portfolio construction now in order to get more QBI deduction?

As said previously, REITs tend to have twice (if not more) the dividends of other investments because they are required by law to distribute 90% of their profits in dividends. Currently, the dividend yield for Vanguard’s REIT ETF (VNQ) is 4.51% while the dividend yield for Vanguard’s S&P 500 ETF (VOO) is only 2.07%. Although 20% of those dividends will receive a deduction if they are in a taxable account, the remaining 80% of those dividends are just taxable income.

Furthermore, although the QBI deduction deducts 20% of REIT dividends from taxable income, the full 100% is still included in AGI.

Thus, including more REITs in your taxable brokerage account for the purpose of the QBI deduction is a losing strategy. It will make your ordinary dividends 1.6 times larger for the purpose of your tax owed and 2 times larger for the purpose of your AGI.

It is better to shelter your REITs in your IRAs where the dividends are not a taxable event at all. This is as though you were receiving a 100% deduction of your REIT dividends.

For more information on this and other asset location strategies, read “Asset Location Can Significantly Boost After-Tax Returns.”

Photo by Daiga Ellaby on Unsplash