Since their inception in 1960, Real Estate Investment Trusts (REITs) have become an extremely popular option for income investors because of their generous payouts and capital appreciation potential.
However, REIT taxes are an important issue to understand.
Conservative investors often favor REITs over traditional stocks because variables that typically have a negative impact on the broader market tend to have a less powerful effect on REITs.
They’re not completely insulated, but it usually takes a down market longer to hit a REIT thanks to rising rental prices and the historic appreciation of real estate in general.
Before diving into REIT taxation, let’s quickly review what REITs are.
What Is a Real Estate Investment Trust?
A REIT is an independent investment company that purchases real estate for the sole purpose of generating regular, predictable current income.
Through extensive portfolios, which typically consist of commercial properties such as corporate offices, warehouses, shopping malls, and apartment complexes, REITs provide income to shareholders in the form of dividends.
To put it simply, REITs are somewhat similar to mutual funds, only the focus is on purchasing income-generating real estate as opposed to traditional stocks and bonds.
Legally, a REIT must pay out at least 90% of its taxable income as dividends. Since those dividends are actually the taxable portion of the income generated by the REIT-owned properties, the company is able to pass its tax burden to shareholders rather than pay Federal taxes itself.
Taxation of REITs
The income tax liability faced by REIT shareholders can be very complicated, which is putting it lightly, actually.
Every distribution, or dividend payout, received by investors in taxable accounts is comprised of a combination of funds acquired by the REIT from a range of sources and categories, each with its own tax consequences.
The result is a mishmash of monies that must be properly separated and categorized to determine the shareholder’s taxable amount due. Let’s take a closer look at REIT taxes.
Often, the bulk of REIT dividend payouts simply consists of the company’s operating profit. As a proportional owner of the REIT company, this profit is passed through to the shareholder as ordinary income and will be taxed at the investor’s marginal tax rate as non-qualified dividends.
However, sometimes REIT dividends will include a portion of operating profit that was previously sheltered from tax due to depreciation of real estate assets.
This portion of the payout is considered a non-taxable return of capital, and while it reduces the tax liability of the dividend, it also reduces the investor’s per-share cost basis.
A reduction in cost basis will have no impact on the tax liability of current income generated by REIT dividends, but it will increase taxes due when the REIT shares are eventually sold.
Another portion of REIT dividends may consist of capital gains. This occurs when the company sells one of its real estate assets and realizes a profit.
Whether the capital gains are deemed short-term or long-term is dependent upon the length of time the REIT company owned that particular asset before it was sold.
If the asset was held for less than one year, the shareholder’s short-term capital gains liability is the same as his marginal tax rate.
If the REIT held the property for more than one year, long-term capital gains rates apply; investors in the 10% or 15% tax brackets pay no long-term capital gains taxes, while those in all but the highest income bracket will pay 15%.
Shareholders who fall into the highest income tax bracket, which is currently 37%, will pay 20% for long-term capital gains.
Let’s consider an example that’s a relatively common scenario involving REIT dividend taxation:
You own a stake in a REIT that pays a dividend of $2.42 per share annually. If, at the end of the year, management declares that 20% of the payout, or $0.48, came from depreciation of the company’s properties, then only $1.94 was net profit.
In this case, only $1.94 of the $2.42 per share dividend is considered ordinary income. If we suppose, for this example, that you purchased the REIT more than a year ago for a price of $45 per share, your cost basis would decrease by $0.48 to $44.52 per share.
When you later sell your stake, your long-term capital gain would be calculated on the theoretical reduced purchase of $44.52, rather than the actual price of $45 that you paid for each share.
This information is a lot to take in, and the notion of performing all those calculations when tax time comes around is enough to give anyone a headache.
Luckily, though, REITs will do much of the heavy lifting for you; at the end of each calendar year, shareholders will receive forms 1099-DIV and 8937.
These forms properly breakdown the ratio of taxable to non-taxable dividend payments, as well as the method used by management to calculate the return-of-capital percentage.
If you are a glutton for punishment, you are welcome to review some of Realty Income’s (O) 8937 tax forms here
Tax Reform Benefits REITs
The 2017 Tax Cuts and Jobs Act brings two important benefits for REITs and their shareholders. Most notably, thanks to the new 20% deduction on pass-through income through the end of 2025, individual REIT shareholders can now deduct 20% of taxable REIT dividend income they receive (but not for dividends that qualify for the capital gain rates). There is no cap on the deduction, no wage restriction, and you do not need to itemize deductions to receive this benefit.
The new tax law effectively lowers the federal tax rate on ordinary REIT dividends (mortgage REITs included) from 37% to 29.6% for a taxpayer in the highest bracket. This level is still above the 20% maximum tax rate on qualified dividends paid by corporations, but it is a nice step in the right direction.
Given the new pass-through deduction, plus the favorable treatment of REIT dividends classified as a return of capital or a capital gain, owning certain REITs in a taxable account could make sense for some investors, especially those who expect to maintain a marginal tax rate in excess of 30% in retirement. However, most investors are likely still better off holding REITs in nontaxable accounts such as 401(k)s and Roth IRAs.
REIT fundamentals should benefit from tax reform as well since the corporate tax rate was reduced from 35% to 21%. While that reduction does not directly benefit REITs since they do not pay taxes as pass-through entities, it will benefit many of their tenants.
For example, retail pays the highest corporate tax rate of any industry in America, according to Accounting Today. Retail REITs are a substantial component of the Real Estate sector, and their tenants should enjoy a nice earnings boost from tax reform. Lower taxes for consumers and businesses should be good news for the economy, rental rates, and property values, all else equal.
Closing Thoughts on REIT Taxes
Given the potentially substantial income tax liabilities and benefits of REITs, it usually isn’t ideal to include them in ordinary taxable portfolios.
Qualified accounts such as traditional or Roth IRAs and 401(k)s are better suited to take full advantage of REIT dividends. The tax-deferred/tax-free status of these retirement accounts only serves to further demonstrate the income-producing potential of a well-run REIT.
Bear in mind, however, that REITs are rather complex investments and are typically appropriate for only a portion of your retirement portfolio.