Mortgage REITs Could Be Big Winners in Tax Reform

By Stuart E. Leblang, Michael J. Kliegman ,and Amy S. Elliott

The mortgage real estate investment trust (REIT) could become relatively more attractive than other vehicles and structures for holding mortgages if either the Senate or House tax reform bills are enacted into law.  While traditional REITs and master limited partnerships (MLPs) will also benefit from the tax reform bills in the Senate and House, their investments can be held in other entities that are similarly advantaged.  However, mortgage REITs will have a clear advantage over other investment entities formed to hold mortgages.

A traditional REIT holds income-producing real estate such as office buildings.  A mortgage REIT holds residential and commercial mortgages or related securities.  A mortgage REIT can either originate the mortgages itself or acquire mortgages in the secondary market.  A mortgage REIT can also hold mortgage-backed securities (MBSs).  Mortgage REITs earn interest income.

Interest income is usually taxed at ordinary rates, which, in the Senate bill, could be as high as 38.5 percent for individuals (or 39.6 percent in the House bill). ¹ 

• Ignoring the net investment income tax (NIIT) and state and local tax (SALT) impacts, income from non-REIT investment entities—private debt funds or regulated investment companies such as mutual funds that hold mortgages or MBSs—could be taxed at 38.5 percent if the Senate bill is enacted or 39.6 percent if the House bill is enacted.

In general, REIT dividends are not eligible for the current law preferential dividend rate and are taxed at ordinary rates.  But the Senate bill provides that dividends from a REIT may be treated as items of domestic qualified business income for purposes of the 23 percent pass-through deduction.  Plus, the Form W-2 wage cap that applies in some cases to reduce the amount of the 23 percent pass-through deduction does not apply to REITs.

• Under the Senate bill, the interest income generated by a mortgage REIT’s investments and paid out to investors as dividends could be effectively taxed at 29.6 percent (assuming the top income bracket but excluding the NIIT or SALT impacts). That creates an 8.9 percentage point tax advantage for the mortgage REIT over alternative mortgage investments.

The House bill would provide a special 25 percent rate on certain business income of pass- through entities.  When earned by passive investors, any interest income properly allocable to a trade or business and that is derived from active business activity is eligible for the 25 percent rate.  In addition, most dividends from a REIT are treated as eligible for the 25 percent rate.  Assuming the mortgage REIT is in an active business originating mortgages, its passive investors who receive dividends would benefit from the special rate.

• Under the House bill, the interest income generated by a mortgage REIT’s investments and paid out to investors as dividends could be effectively taxed at 25 percent (excluding the NIIT or SALT impacts). That creates a 14.6 percentage point advantage for the mortgage REIT over alternative mortgage investments.

The low rates available on interest income from mortgage REITs in the Senate and House bills may not be similarly available if the income comes from mutual funds or private debt funds (other than, under the House bill, certain private debt funds that are in the active business of originating mortgages).

Some of the

Traditional property REITs and energy-related MLPs also benefit from the pass-through provisions (the 23 percent deduction in the Senate and the special 25 percent rate in the House), but the investments that they hold may, in certain cases, also be held in private or public entities that may be eligible for similar tax benefits (recall, too, that real estate is a big winner in both bills, with favorable depreciation rules and the ability to avoid the net interest expense deduction limit).

While we do not know which pass-through provision—the Senate’s deduction or the House’s special rate—will win the day, assuming tax reform gets across the finish line, mortgage REITs will be tax advantaged for taxable investors.

One or more authors may have positions in stocks referred to in this article.

^{[1] Moreover, these rates do not include the 3.8 percent net investment income tax (NIIT) or the impact of repealing the state and local tax (SALT) deduction for individuals, the latter of which could add an additional 5.8 percentage points of tax on the interest income earned by Californians, for example.  Assume a California taxpayer receives $100 of interest income.  If the SALT deduction for state income taxes were preserved, a Californian would be able to deduct the 13.3 percent of state income tax she paid on the $100, meaning that the 43.4 percent tax levied in the House bill would be on $86.70, resulting in about $37.60 of federal tax due.  However, because the House bill would not allow individuals to deduct the amount they pay in state income tax, the 43.4 percent is levied on $100, resulting in $43.40 of federal tax due, or an increase of about 5.8 percentage points.}