Cost Segregation for REITs

Real estate investment trusts are taxed under Subchapter M of the Internal Revenue Code. REITs that meet specific qualification requirements can deduct dividends paid to shareholders, effectively avoiding entity-level taxation on distributed income.

To qualify as a REIT, the entity must distribute at least 90% of taxable income to shareholders annually. It must also meet asset tests, income tests, and organizational requirements. REIT depreciation reduces taxable income, which reduces the required distribution amount.

For cost segregation purposes, REITs calculate depreciation at the entity level using the same methods as other taxpayers. The accelerated depreciation from cost segregation reduces taxable income and can improve cash flow by reducing the required distribution.

Cost segregation reit implementation follows the same engineering and tax principles as other entities. The REIT reclassifies building components into shorter depreciation lives, which increases depreciation deductions in earlier years.

The increased depreciation reduces the REIT's taxable income, which can reduce the required distribution to shareholders. However, REITs often distribute based on cash flow rather than taxable income, so the tax benefit may be retained at the REIT level or used to fund future acquisitions.

Understanding how entity structure affects tax planning is critical when evaluating whether a REIT structure is appropriate for your real estate portfolio and whether cost segregation delivers meaningful tax benefits.

REITs must distribute at least 90% of taxable income to maintain REIT status. Cost segregation reduces taxable income by accelerating depreciation deductions, which reduces the amount that must be distributed to shareholders.

This can be beneficial for REITs that want to retain cash for acquisitions, capital improvements, or debt service. By reducing taxable income, cost segregation allows the REIT to distribute less while still meeting the 90% requirement.

However, REITs often distribute more than the required amount based on cash flow, investor expectations, and distribution policy. In these cases, the tax benefit of cost segregation is less direct but can still improve the REIT's overall tax efficiency and reduce the tax burden on shareholders.

REIT shareholders do not directly receive depreciation deductions. Instead, the REIT's depreciation reduces the REIT's taxable income, which reduces the amount of ordinary dividend income reported to shareholders.

REIT dividends are generally taxed as ordinary income at the shareholder level. However, a portion of the dividend may be classified as capital gain distribution or return of capital, depending on the REIT's earnings and profits and the character of its income.

Cost segregation does not change the character of the dividend, but it can reduce the amount of ordinary dividend income reported to shareholders by reducing the REIT's taxable income. This can be beneficial for high-income shareholders who want to minimize ordinary income.

REITs can use bonus depreciation on qualified property, including reclassified components from cost segregation. This significantly increases first-year depreciation and reduces taxable income in the acquisition year.

Bonus depreciation is particularly valuable for REITs that acquire properties in years when they expect high taxable income. By accelerating depreciation, the REIT can reduce the required distribution and retain more cash for future investments.

However, bonus depreciation phases down over time and may not be available at full rates in future years. REITs should coordinate with their tax advisors to determine the optimal timing and strategy for implementing reit accelerated depreciation.

REITs must track earnings and profits to determine the tax treatment of distributions to shareholders. Depreciation reduces earnings and profits, which can affect the character of distributions and the REIT's ability to pay dividends.

Distributions in excess of current and accumulated earnings and profits are treated as a return of capital, which reduces the shareholder's basis in their REIT shares. Distributions in excess of basis are treated as capital gain.

Cost segregation increases depreciation, which reduces earnings and profits. This can result in a larger portion of distributions being classified as return of capital, which defers tax for shareholders but reduces their basis and increases future capital gain on sale of the shares.

When a REIT sells property, depreciation recapture is taxed at the entity level. The recapture reduces the REIT's taxable income for that year and affects the amount available for distribution to shareholders.

Personal property depreciation is subject to ordinary income recapture under Section 1245. Real property depreciation is generally not subject to recapture but may be subject to unrecaptured Section 1250 gain at 25% when the property is sold.

REITs should model the disposition impact before implementing reit tax strategy that relies heavily on accelerated depreciation. The recapture liability can offset the tax benefits realized during the holding period, particularly for properties held for shorter durations.

Both public and private REITs can implement cost segregation. Private REITs may have more flexibility in distribution policies and may be more aggressive in tax planning because they are not subject to the same disclosure and reporting requirements as public REITs.

Public REITs must report financial results to the SEC and investors, which may limit their willingness to implement strategies that reduce reported earnings. However, the fundamental tax rules and benefits of cost segregation are the same for both public and private REITs.

For more on how trusts and estates use cost segregation, review the dedicated page, which discusses similar entity-level tax considerations.

REITs offer liquidity and diversification benefits but do not pass depreciation deductions directly to shareholders. Partnerships and LLCs pass depreciation through to owners, allowing individual investors to use the deductions against other income subject to passive activity rules.

For investors who can use depreciation deductions, a partnership or LLC structure may be more tax efficient than a REIT. For investors who cannot use passive losses or who value liquidity and professional management, a REIT may be the better choice.

The entity choice should balance tax, liquidity, and investment objectives. Work with your CPA and financial advisor to determine the best structure for your real estate portfolio.