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Here's Why REITs Make Such Great Retirement Investments

By Matthew Frankel, CFP® – Sep 23, 2021 at 8:03AM

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The unique tax structure of REITs make them ideal for retirement accounts.

Real estate investment trusts, or REITs, have a tax structure that can complicate your brokerage account, unless your brokerage account is an IRA. In this Fool Live video clip, recorded on Sept. 3, Millionacres senior real estate specialist Matt Frankel, CFP, discusses the tax structure of REITs and why they're such a great way to invest for retirement.

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Matt Frankel: Another question. Charles says, "Are there any special tax implications with REITs compared to stocks or bonds?" Yes. Very good question. REITs themselves are very tax-advantaged investment. Nothing you have to worry about, nothing you have to do special on your taxes right yet. Generally, most dividend stocks are effectively taxed twice. Let's say that you own Apple stock and Apple made a big profit this quarter and wants to pay a dividend, it will pay tax on its profit at the corporate level, and then when they distribute the dividend to you, it could be taxable as individual income, so the same money is effectively being taxed twice. Excuse me.

REITs on the other hand are considered pass-through investments, kind of like if you own an LLC, they don't pay tax on the corporate level as long as they distribute a certain amount of their income, big tax advantage for investors. The special tax implications that I think Charles is referring to there is that because they have that special pass-through tax treatment, they don't get the preferential qualified dividend treatment that most stock dividends do. Instead of being taxed at favorable tax rates, most dividends are taxed as long-term capital gains; most taxpayers get a 15% tax rate, I think the highest is a 20% tax bracket. REITs on the other hand are taxed as ordinary income, meaning that they're taxed at your normal tax bracket. But there are a few little complications with that. 

For one thing, REIT dividends qualify for the 20% pass-through tax deduction, which is a good thing but adds complication. As part of the Tax Cuts and Jobs Act, pass-through income was given a special tax rate where the recipient can write off up to 20% of their pass-through income, so REIT dividends qualify for that. REIT dividends can be made of a few different types of income. Most REIT dividends are considered ordinary income, like I just mentioned, taxable at your regular tax rate. There is a chance, depending on how the REIT made its money, that some of it could be considered a qualified dividend, some of it could be considered a non-taxable distributions and a return of capital. That happens a lot if REITs sell a lot of their properties and distribute some of the money to shareholders, that can be non-taxable income. Definitely, some tax implications, they complicate your taxes a little bit, assuming you own your REITs in a taxable account.

Most of my REITs and for most investors, most REITs are owned in retirement accounts. You get this really unique double tax benefit by doing that. Not only do you not pay tax on the corporate level because of the special treatment that REITs get but if you have them in your retirement accounts, you don't have to pay that individual income tax as well, so it's essentially tax-free profits that aren't taxable at all until if you have a traditional IRA or 401(k) are only taxable when you withdraw the money.

Matthew Frankel, CFP owns shares of Apple and has the following options: short November 2021 $140 calls on Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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