Dividends are the primary reason why investors turn to real estate investment trusts or REITs. However, what many people fail to realize is that REIT dividends are not taxed like normal dividend stocks. Due to the complex nature of the tax code, understanding the REIT taxation rules is crucial to avoid being hit with a hefty charge when filing taxes.
How Are REITs Taxed?
Real estate investment trusts were created to provide small investors with access to large income-producing real estate assets, similar to how mutual funds offer access to stocks. To incentivize this, REITs were given a special tax designation that allows them to reduce their corporate taxes.
In exchange for these corporate tax benefits, REITs are required to distribute 90% of their taxable income to shareholders in the form of dividends. While this simplifies things from a corporate standpoint, it introduces confusion for shareholders.
Each year, shareholders receive Form 1099-DIV, which breaks down the dividend distribution into three categories: ordinary income, capital gains, and return of capital. To complicate matters further, each distribution is subject to a different tax rate.
Ordinary Income
Since REITs are not taxed at the corporate level, dividends are taxed as ordinary income. Ordinary REIT dividend payments are reported in Box 1a - Total Ordinary Dividends on the 1099-DIV. This portion of the dividend distribution is taxed at your marginal income tax rate.
While this is beneficial for investors in lower tax brackets, it eliminates the advantage REITs have over other dividend stocks for higher income investors. It's important not to confuse ordinary income with qualified dividends, which are taxed as capital gains.
Capital Gains
There are three ways in which REITs can be subject to capital gains tax. The first is similar to any traditional capital gain, where you buy REIT shares and sell them at a higher price, resulting in a profit that is subject to capital gains tax.
The second scenario arises from qualified dividends (Box 1b on the 1099-DIV). These dividends are paid on the small portion of a REIT's income that is subject to corporate tax or income from a subsidiary. In most cases, this is rare.
The third way a REIT can be subject to capital gains tax is through a return of capital distribution.
Return of Capital
If a REIT sells an asset, such as an office building, it can reinvest the proceeds or distribute them to shareholders. Any amount paid to shareholders is reported in Box 3 - Nondividend Distribution on Form 1099-DIV.
Return of capital refers to any amount that exceeds the REIT's taxable income. Instead of being taxed as ordinary income, it reduces the cost basis of your shares. Cost basis is simply the value of the shares at the time of purchase.
For example, if you bought 100 shares of XYZ REIT at $10 per share, your cost basis would be $1,000. If later, the 1099-DIV shows a return on capital of $1 per share, your initial cost basis would be reduced to $9 per share ($10/share - $1 return on capital), making your total cost basis $900 for the 100 shares of XYZ REIT.
However, you are still responsible for paying taxes. You will eventually pay capital gains tax on the difference between the selling price and your new cost basis, but only when you sell those shares. It's worth noting that if the share price drops below your new cost basis, you may report a loss.
Use a Retirement Account
When dealing with REITs and taxes, one last thing to consider is the advantage of owning REITs inside retirement accounts, such as IRAs and other tax-advantaged accounts. These accounts offer protection from the REIT tax rules, as any earnings are only taxed upon withdrawal, if at all.
Understanding the REIT taxation rules is crucial for investors to navigate the complexities and optimize their tax strategies. By familiarizing yourself with how REITs are taxed, you can make informed investment decisions and potentially reduce your tax liability.