Since their inception in 1960, Real Estate Investment Trusts, or REITs, have become an extremely popular option for income investors because of their reliable payouts and immense 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 in to 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 (learn the difference between qualified and non-qualified dividends here).
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 39.6%, 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 stake in Realty Income Corp (O), which is a REIT that trades for $66 per share. Currently, the dividend yield for Realty Income Corp is 3.61%, or $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 Realty Income Corp more than a year ago for a price of $45 per share, your cost basis would decrease to $44.52 per share. When you later sell your stake, your long-term capital gains 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, the REIT company 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 8937 tax forms here.
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 much 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 beasts and are typically appropriate for only a portion of your retirement portfolio.
The assistance of an experienced financial advisor can help, particularly for investors seeking immediate income and those considering a REIT within a taxable brokerage account.