To be classified as a real estate investment trust, or REIT, a company must meet strict requirements. For one thing, it needs to invest at least 75% of its assets in real estate. It also has to derive at least 75% of its income from these assets. In addition, REITs must have at least 100 shareholders and no five shareholders can control a majority of a REIT’s outstanding shares.
Perhaps the most well-known of the REIT requirements is that it must pay out at least 90% of its taxable income to shareholders. Most REITs end up paying out all of it.
Which is great. But it comes with some tax implications that you need to know.
How REITs are taxed
Because of this last requirement, REITs are treated as pass-through entities for tax purposes. LLCs and partnerships are also pass-throughs. Imagine that you and two business partners own a convenience store. Your proportional share of the business’ income is passed to you and you’ll report it as income on your individual tax return.
As a pass-through business, a REIT's profits aren't taxed on the corporate level. It doesn’t matter if the REIT’s profits are in the billions -- as long as it meets the REIT requirements, it won’t pay a dime in corporate taxes.
This is a huge benefit for REIT investors. With most dividend-paying stocks, profits are effectively taxed twice. First, the company pays corporate tax on its earnings (currently taxed at a 21% rate). Then shareholders are taxed again when these profits are paid out as dividends.
To be fair, REITs aren’t completely tax-exempt. They still pay property taxes on their real estate holdings, for one thing. And there are some situations where REITs need to pay income taxes.
REIT dividends can be complicated
REITs enjoy a simple tax structure on the corporate level. But when it comes to individual taxation of REIT dividends, it's more complicated.
For starters, most REIT dividends don’t meet the IRS definition of "qualified dividends." These dividends are taxed at the same rates as long-term capital gains taxes. That can be 0%, 15%, or 20%, depending on your income. The key point to know is that these are always lower than the corresponding marginal tax brackets applied to ordinary income.
The majority of REIT dividends are ordinary income for tax purposes. So if you’re in the 24% tax bracket, the IRS applies that tax rate to most dividends you receive from your REITs.
However, it’s not that easy. Some of the distributions you receive from your REITs may indeed count as qualified dividends (although it’s typically a small amount). And some may qualify as long-term capital gains, which often occurs if the REIT sold some of its properties. Others may be considered a return of capital, which isn't taxable but can lower your cost basis, resulting in additional capital gains tax when you sell.
Confused yet? It gets even more complicated (but in a good way). The part of your REIT dividends that is ordinary income -- which is likely to be the lion’s share -- qualifies for the Qualified Business Income (QBI) deduction. This lets you take a deduction of up to 20% of your pass-through business income. That includes REIT distributions.
An example of REIT dividend taxation
Fortunately, REITs break down their dividends into the different tax categories and your brokerage will put them on your tax forms each year. Let’s take a look at an example and what it could mean when tax time rolls around.
First, consider the tax treatment of the 2018 distributions from healthcare REIT Welltower (NYSE: WELL):
|Classification||Amount||% of Total|
|Long-term capital gains||$1.115292||32.0%|
|Return of capital||$0.165924||4.8%|
Let’s say you own 1,000 shares of Welltower, which means you received $3,480 in total distributions in 2018. For the sake of this example, we’ll say you’re in the 24% tax bracket and the 15% bracket for long-term capital gains.
- First, about $2,199 of the distribution would be taxed at your ordinary income tax rate. But you could deduct 20% of this with the QBI deduction, so your 24% marginal tax rate would only be applied to $1,759. That's $422 in tax liability.
- Next, the 15% long-term capital gains rate would be applied to $1,115 of your distributions. That's another $167 in taxes.
- Finally, the return of capital isn't subject to tax this year. But, as I mentioned, it could increase your tax liability when you sell.
So you’d end up paying $589 on your $3,480 in distributions, an effective tax rate of about 17%.
How to avoid the complicated and expensive tax on REIT dividends
This discussion is a moot point if you hold your REITs in tax-advantaged retirement accounts. REITs are popular retirement investments for this reason. You don’t have to worry about paying dividend taxes each year. And you don't need to worry about complicated capital gains taxes when you sell shares of a REIT.
If you own REITs in tax-deferred accounts, like a traditional IRA or 401(k), you won’t pay taxes until you withdraw money from the account. Funds in these accounts can continue to grow tax-deferred as long as they’re in the account. And they're treated as taxable income (ordinary income) when the money is eventually withdrawn. Plus, contributions to these accounts are generally tax-deductible in the year they’re made.
On the other hand, if you own REITs through an after-tax account like a Roth IRA or Roth 401(k), you won’t ever have to pay taxes on your REIT dividends and capital gains, even when you withdraw from the account. The drawback is that contributing to a Roth account doesn’t get you any immediate tax benefit. But that's a small price to pay to avoid future taxation on qualified withdrawals.
The key takeaways
REIT taxation can be complex and costly on the individual level. The QBI deduction helps, but you’re still likely to pay a higher effective tax rate on your REIT dividends than you do on other dividends you receive.
This is why REITs make such excellent candidates for retirement investments. Consider buying REITs through your IRA or other tax-advantaged retirement account before buying them in a standard taxable brokerage account.
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