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REIT Investing 101: How to Keep REIT Taxes to a Minimum

REIT dividends are generally treated as ordinary income, but there are ways to reduce your tax liability.

[Updated: Feb 04, 2021] Aug 22, 2019 by Matt Frankel, CFP
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The dividends from real estate investment trusts, or REITs, are usually taxed at your marginal tax rate. But that's not the whole story.

Let's take a look at:

  • why REITs are still tax-advantaged investments,
  • how the IRS treats REIT dividends,
  • a deduction that can help reduce the taxes you pay on your REIT investments, and
  • the best way to avoid REIT taxes altogether.

REITs don’t pay corporate tax on their profits

To be classified as a REIT, a company needs to do more than make real estate its primary business activity. It needs to meet some strict requirements. For example, it must pay out at least 90% of taxable income as dividends. And it has to get at least 75% of income from real estate activities.

Why the strict requirements? Because REITs get a big tax benefit. No matter how much money a REIT makes, it pays no corporate taxes whatsoever. Instead, it's treated as a pass-through business like an LLC or S corporation.

This is a big benefit for REITs and their investors. With most dividend stocks, profits are effectively taxed twice -- once on the corporate level when they’re earned, and again on the individual level when they’re paid out as dividends. REIT dividends are only taxed when they're received by investors.

REIT dividends can be complex

There's a downside to being a pass-through entity. REIT dividends generally don't receive the same favorable tax rates that most dividends do.

Most dividends are "qualified dividends," so recipients pay the same lower tax rates that apply to long-term capital gains. These rates are 0%, 15%, or 20%, depending on the taxpayer’s income. That's lower than the ordinary income tax rates throughout the entire income spectrum.

REIT dividends are generally treated as ordinary income. For example, a taxpayer in the 24% marginal tax bracket would pay a 15% tax rate on qualified dividends but 24% on REIT dividends.

These dividends can also be rather complex for tax purposes. Most REIT distributions are considered ordinary income, but some may be qualified dividends or long-term capital gains. And some could be considered a return of capital, which isn’t taxable at all ... but it lowers your cost basis in the REIT and could increase your tax bill when you sell. Most REIT distributions are ordinary dividends, with the other two categories making up small amounts.

As an example, here’s how the dividends paid by healthcare REIT Welltower (NYSE: WELL) broke down in 2018:

Classification Dollar Amount % of Total
Ordinary (non-qualified) dividends $2.198784 63.2%
Qualified dividends $0.000000 0.0%
Long-term capital gain $1.115292 32.0%
Return of capital $0.165924 4.8%
Total distributions $3.480000 100%

Data source: Welltower.

The pass-through deduction applies to REIT dividends

The part of REIT distributions that's considered ordinary income qualifies for the pass-through tax deduction from the Tax Cuts and Jobs Act.

Also known as the Qualified Business Income (QBI) deduction, this allows up to 20% of taxpayers’ income from pass-through entities to be deducted.

Being able to take the full deduction is subject to income restrictions, so be sure to look into the details before you claim the deduction. It’s also worth noting that tax-preparation software will likely apply this deduction for you. If you do your return by hand, make sure to take this deduction -- it can save you a lot of money in REIT dividend taxes.

REITs make fantastic retirement investments

The hands-down best way to avoid taxes on REIT investments is to hold them in tax-advantaged retirement accounts such as IRAs.

In retirement accounts, you don’t need to worry about paying dividend taxes each year, nor do you need to worry about capital gains taxes when you sell stocks. Since most REIT dividends are considered ordinary income and there’s also the "return of capital" element of REIT dividends that can increase your capital gains taxes, REITs make ideal candidates to hold in retirement accounts. If you have to choose between keeping REITs or standard dividend stocks in your retirement accounts, REITs are likely the better choice.

Holding your REITs in retirement accounts allows you to reinvest 100% of your dividends, which is essential for maximizing long-term compounding power.

If you hold your REITs in a traditional IRA or another tax-deferred retirement account, you won’t have to pay any taxes until you withdraw money from the account. Traditional IRA contributions are generally tax-deductible, so traditional IRA withdrawals are taxable income.

On the other hand, if your REITs are in a Roth IRA or another after-tax retirement account, you won’t have to pay a dime of tax on your REIT profits, even when making qualified withdrawals. Because you don’t get a tax deduction when contributing to a Roth IRA, you've already paid tax on your contributed money and your withdrawals are 100% tax-free -- even if your REIT holdings are worth significantly more than you paid for them.

The key takeaways on REIT dividend taxation

REITs are already tax-advantaged investments, as they're exempt from corporate income taxes on their profits. This is because REITs have to distribute most of their income to shareholders and are considered pass-through entities.

If you hold your REITs in a standard (taxable) brokerage account, most of your REIT dividends will be treated as ordinary income. However, it’s possible that some portion of your REIT dividends will meet the IRS definition of qualified dividends, and that some could be considered a non-taxable return of capital.

REIT dividends that are considered ordinary income meet the criteria for the new Qualified Business Income deduction. This allows for as much as 20% of your REIT distributions to be taken as a tax deduction.

The best way to avoid paying taxes on your REITs is to hold them in tax-advantaged retirement accounts, including traditional or Roth IRAs, SIMPLE IRAs, SEP-IRAs, or another tax-deferred or after-tax retirement accounts.

If you put these tips to use, you can save yourself hundreds or thousands of dollars on your investment taxes.

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Matt Frankel has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.