Don’t Get Caught by Surprise Taxes: What You Need to Know About REIT Dividends and Tax Implications
Real Estate Investment Trusts (REITs) own or invest in income-producing real estate.
There are three typical REITs:
- Equity REITs, the largest category, own and operate physical properties, like apartment building or even Self-Storage REITs.
- Mortgage REITs don’t own or operate physical properties; these companies invest in mortgages and mortgage-backed securities.
- Hybrid REITs mix the two and may invest in mortgages while owning physical properties.
Regardless of the REIT type and its availability (publicly-traded or a non-traded REIT, the IRS considers REITs pass-through entities.
A pass-through entity is not subject to standard corporate income taxes. Instead, the income and cash flow are distributed directly to the shareholders, who are, in turn, responsible for the taxes on their share of the REIT’s taxable income.
To qualify as a REIT, these companies must legally distribute at least 90% of their taxable income to their shareholders as dividends.
How Are REIT Dividends Taxed ?
There are two primary differences in REIT dividend taxation compared to other investable assets:
- REIT dividends are usually taxed at the ordinary income rate rather than as long-term capital gains.
- REIT dividends may include a portion of the investor’s return of capital (ROC).
Dividend Tax Rate
REIT dividend taxes and those owed on typical stock dividends differ in that REIT dividends are generally taxed at ordinary income tax rate rather than as qualified dividends subject to a lower long-term capital gains rate.
That ordinary income rate, commonly known as your ‘tax bracket’ rate, is generally higher than qualified dividends. However, qualified dividends from a regular company’s excess earnings distributions are usually subject to the long-term capital gains tax rate.
In the United States, ordinary income tax rates range from 10% to 37%, whereas long-term capital gains tax rates range from 0% to 20% – the wide variance depends on your income level, so it’s best to touch base with your tax advisor to see what your specific situation demands.
For easiness’ sake, we’ll assume you’ve invested $10,000 in a standard stock (XYZ) and the same amount in a REIT; both distribute $500 annually as a dividend.
We’ll say that the entire $500 dividend is qualified for your XYZ investment. Qualified, in this case, means that it’s taxed at a long-term capital gains tax rate of 15%. Come tax time, you owe $75 on the dividend ($500 x 15%).
The entire $500 dividend for the REIT is ordinary income, so it’s taxed at your marginal tax rate, which we’ll peg at 25%. In this case, you owe $125 in taxes on the REIT dividend ($500 x 25%).
In this example, the tax on the REIT dividend is higher than the tax on your qualified dividend from XYZ because the REIT is legally required to distribute at least 90% of its taxable income to shareholders – cash flow generally considered ordinary income, so it’s taxed at higher rates.
REITs may receive a Return of Capital
REIT dividends are also subject to a unique tax treatment if a portion of the dividend is classified as a return of capital (ROC).
ROC is a chunk of the dividend paid to REIT shareholders considered a return of their original investment instead of taxable income from the REIT’s operations.
Although the ROC portion of the dividend isn’t subject to immediate taxation, it does reduce the investor’s cost basis in the REIT shares they own. Ultimately, when you sell your shares, the lower cost basis creates a higher return and demands higher taxes on those gains.
There are several reasons why REITs might choose to issue a Return of Capital:
Since REITs are required by law to distribute at least 90% of their taxable income to shareholders annually, classifying a portion of the dividend as ROC helps investor defer taxation for as long as they own shares in the company.
Cash flow management
REITs often use ROC to manage their cash flow. If a REIT sees a large capital expenditure on the horizon or is in the process of acquiring new properties, the REIT conserves cash to fund activities by returning capital to investors.
Some investors prefer ROC over income-based dividends because it may be more tax-efficient. ROC also helps investors avoid taxes on “phantom income,” which sometimes happens when a REIT distributes more than its taxable income.
Suppose you invested $10,000 in a REIT and received $500 in dividends during the year. Of that distribution, $200 is classified as Return of Capital.
- Amount Invested: $10,000
- Dividends during the year: $500
- Return of Capital: $200
Here’s how the ROC affects your taxes:
- Taxable income: $300 ($500 total dividends – $200 ROC).
- Adjusted cost basis: $9,800, because the $200 ROC drops your cost basis from $10,00 to $9,800.
- Capital gains: $2,200. f you sell REIT shares later for $12,000, your capital gain calculations use your adjusted cost basis of $9,800 istead of the original $10,000 cost basis.
In this scenario, the ROC component of the dividend reduces your taxable income from the REIT dividends that year but increases your capital gains tax liability later when you trim the position or sell all shares.
It’s important to note that this is a simplified example; specific tax implications of ROC and REIT dividends vary based on individual circumstances and the tax laws in your state or country.
PRO TIP: Not all REIT dividends include a Return of Capital component. The amount of ROC in REIT dividends can vary depending on the REIT’s financial performance and other factors.
When a REIT generates dividends, the company sends a 1099-DIV form at the end of the year.
This form shows the total dividends received, and breaks them down as ordinary income and return of capital, depending on the REIT’s distribution structure that period.
The Bottom Line
Although REIT investing can provide a steady income stream, it’s important to understand the tax implications of REIT dividends.
REIT dividends are typically classified as ordinary income and may include a portion classified as a return of capital.
If you’re in a high-income bracket, it may be worth considering moving to a dividend-paying stock with comparable yield to reduce dividend tax burden – especially if you’re investing in a taxable brokerage account.
Either way, consult with a tax professional to understand the tax implications of your REIT investments based on your circumstances.
Frequently Asked Questions
How are REIT dividends taxed if they are reinvested?
When you reinvest your REIT dividends, the tax treatment is the same as receiving the dividends in cash. This means that the reinvested dividends are still subject to taxes.
You are essentially using the dividends to purchase additional shares of the REIT. The value of these additional shares is equivalent to receiving cash dividends, and you must pay taxes on the value of the additional shares.
Are REITs Taxed Twice?
Real Estate Investment Trust (REIT) dividends are not taxed twice but are subject to different tax rules than dividends from regular corporations.
Unlike regular corporations, REITs do not pay corporate taxes on their earnings. Instead, the tax burden is passed to shareholders through taxes on the dividends received.
So, while REIT dividends are subject to taxation at the individual level, they are not taxed twice since the REIT itself does not pay corporate taxes on its earnings.