Investing in commercial real estate can be a valuable addition to any portfolio strategy. But when it comes to Real Estate Investment Trusts (REITs), understanding the tax implications is crucial for making informed investment decisions. Today, we'll explore the tax benefits of REIT investments and break down the complexities of the 1099-DIV form.
What is a REIT?
REITs were introduced by the U.S. Congress in 1960 to provide individual investors with the opportunity to invest in commercial real estate. Before REITs, this type of investment was limited to institutional investors. By pooling funds, individual investors can now make meaningful investments in the world of commercial real estate. However, REITs come with specific limitations on structure and operation imposed by Congress to ensure their effectiveness as passive real estate investment vehicles.
How Are Realized Returns Determined?
Before we dive into the tax benefits, let's understand how real estate funds generate returns. Realized returns from real estate investments consist of two components: operating distributions and capital gain distributions. Operating distributions are payments made to investors from the cash flow generated by the underlying real estate investments. This can include net rental income, as well as interest and dividends earned inside the REIT. The second component of realized returns comes from capital gains realized through the sale of real estate within the REIT.
How Are Realized Returns Categorized?
To maintain favorable tax status, a REIT is required to distribute the majority of its taxable income to shareholders. These distributions fall into three categories, each with its own tax treatment:
- Dividend: Taxable based on your ordinary income tax rate.
- Capital Gain: Taxed at either short- or long-term capital gains rate, depending on the holding period.
- Return of Capital: Not subject to taxation, as it is a return of your initial investment.
It's worth noting that if you hold a REIT in a tax-deferred account like a traditional IRA, you will only pay taxes when you withdraw the money from your account.
What Are the Potential Tax Benefits of Investing in a REIT?
REITs enjoy special tax treatment if they meet the requirements outlined by the IRS. Unlike other U.S. corporations, eligible REITs are not subject to double taxation. They can deduct dividends paid to shareholders, avoiding corporate-level income tax. Shareholders, in turn, benefit from preferential U.S. tax rates on dividend distributions from the REIT.
The Tax Cuts and Jobs Act (TCJA) of 2017 further enhanced the tax efficiency of REIT investing. Under the TCJA, many taxpayers can deduct up to 20% of Qualified Business Income, and ordinary REIT dividends qualify as Business Income. This deduction is not subject to income thresholds, making it accessible to all REIT investors regardless of their income level.
Let's take a hypothetical example to illustrate the potential tax benefits. Imagine you invest $10,000 in a REIT with an annual dividend yield of 7%. Assuming you're in the highest 2020 Federal marginal tax bracket of 37%, the after-tax profit would be $493, resulting in an after-tax yield of 4.93%.
Will I Receive a Schedule K-1 or Form 1099-DIV?
When investing in a REIT, you may wonder if you'll receive a 1099 or a K-1. Generally, if you invest directly into a REIT, you'll receive a Form 1099-DIV. This form is issued by the REIT and reports dividends and other distributions valued at $10 or more. Dividend income is taxed in the state(s) of residency, regardless of the property's location.
On the other hand, a Schedule K-1 is an IRS tax form issued annually for an investment in a partnership. It reports each partner's share of the partnership's earnings, losses, deductions, and credits. Real estate income earned through a partnership may be taxed in the state(s) where the property is located. The Schedule K-1 serves a similar purpose as a Form 1099 for tax reporting.
Understanding Your IRS Form 1099-DIV
When you receive your Form 1099-DIV from the REIT, you'll notice several boxes already filled out. Here's a quick breakdown of some of the reporting boxes and their implications:
- Box 1a: Reports the total amount of ordinary dividends you receive.
- Box 1b: Reports the portion of box 1a that is considered qualified dividends.
- Box 2a: Reports capital gain distributions from the REIT.
- Boxes 4 and 14: Report any federal and state taxes withheld from your distributions.
Conclusion
Investing in a compliant REIT brings several tax advantages. REIT shareholders are not subject to corporate taxes, instead paying tax on dividend income at their individual tax rates. Deducting up to 20% of ordinary dividends before income tax assessment adds to the appeal. Additionally, investing in a REIT fund with exposure to multiple properties provides built-in diversification without the complexities of multiple state income tax filings.
While public REITs are more well-known for their tax advantages, considering alternative investments like non-correlative private real estate can further diversify your portfolio. Many high-net-worth individuals and institutions have long allocated their portfolios to alternative investments, but this approach is still gaining traction among individual investors.
Jamestown Invest is a direct-to-consumer platform that connects U.S. individuals with real estate opportunities managed by Jamestown, a global real estate institution.
Remember to consult a tax advisor before making any investment decisions.