Real estate investment trusts are finicky things. In exchange for big dividend yields, you have to be prepared for complex corporate accounting and a few personal tax issues.
Recently, Realty Income Corp. (NYSE:O) outlined its year-end tax information for 2013, and I wanted to help investors make sense of what it means for their income taxes.
The nitty-gritty details
In 2013, Realty Income paid out $2.147 in dividends per share. Some, roughly 61%, of these dividends were ordinary dividends. The other 39% were returns of capital.
Generally speaking, we talk about how REIT dividends are taxed as ordinary income. This is what ordinary dividends are -- ordinary income. They don't get the beneficial tax treatment of qualified dividends, which are taxed at much lower capital gains tax rates.
So, if you held shares of Realty Income Corp. for the full year of 2013, you'll have about $1.315 in ordinary income per share on which you pay income taxes like any other form of income.
Now for returns of capital
REITs often return capital in their monthly or quarterly distributions to shareholders. A return of capital happens when you get money back that does not come from profits, either earned or retained. It's really like getting your money back.
Now, you could search the Internet and find all kinds of warnings about returns of capital. But, for REITs, a return of capital is not a bad thing, per se. You see, REIT earnings are tricky. REITs are required to depreciate real estate each year but often spend very little -- or nothing -- on the property to maintain its value. On the books, depreciation is an expense. But it wasn't a cash expense. It was just an accounting expense.
Thus, a return of capital is only natural. Actual cash generation exceeded accounting earnings, so the excess is deemed a return of capital.
This year, some $0.832 per share of Realty Income's 2013 dividends were returns of capital. This money is not taxed, at least not yet...
How and when return of capital is taxed
Return of capital is not taxed until you sell your shares. Let's create an example. Assume you paid $40 per share to buy Realty Income stock in December 2012. In 2013, you received roughly $0.83 in return of capital.
You don't pay taxes on the return of capital now. Rather, the return of capital goes against your cost basis. So, your cost basis per share drops from the original $40 price to $39.17.
Now, assuming that you sell your shares in the future, you will pay capital gains tax on your adjusted cost basis of $39.17 per share. If you sell for, say, $45 per share, you'll have $5.83 in capital gains on which taxes are due. It's a $5.00 gain per share, plus the $0.83 in return of capital.
Return of capital is essentially a tax-deferred dividend, which is why so many people recommend you don't trade in and out of REITs. You buy them and hold them to defer taxes for as long as you can -- potentially forever.
That's the long and short of how Realty Income shareholders should think about their taxes this year. Luckily, for those of you who hold Realty Income in a taxable account, you'll only need to pay normal income taxes on roughly three-fifths of the dividends you received, assuming, of course, you haven't sold your shares.
Fool contributor Jordan Wathen has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.