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 3 common types of REITs.
Most REITs are equity REITs, which own and operate physical properties. However, some Mortgage REITs do not own or operate physical properties but instead invest in mortgages and mortgage-backed securities. Lastly, hybrid REITs may invest in mortgages and own physical properties simultaneously.
Regardless of the type of REIT you invest in and whether it is a publicly-traded REIT or a non-traded REIT, REITs are considered pass-through entities, which means they are not subject to corporate income taxes. Instead, the income is passed through to the shareholders, who are responsible for paying taxes on their share of the REIT’s taxable income.
To qualify as a REIT, these companies are required by law to distribute at least 90% of their taxable income to their shareholders in the form of dividends.
How Are REIT Dividends Taxed Differently?
There are two main differences in the tax treatment of REIT dividends. The main difference is that REIT dividends are usually taxed at the ordinary income rate, and secondly, a REIT dividend may include a portion of the investor’s Return of Capital.
1. REITs are usually taxed at the ordinary income rate
The most significant difference between REIT dividend taxation and regular stock dividends is that REIT dividends are generally taxed at ordinary income tax rates. In contrast, most stocks are classified as qualified dividends and, therefore, subject to the lower long-term capital gains rate.
The ordinary income rate, commonly known as your ‘tax bracket’ rate, is generally higher than qualified dividends, which are subject to the long-term capital gains tax rate.
In the United States, ordinary income tax rates range from 10% to 37%, while long-term capital gains tax rates range from 0% to 20%, depending on your income level.
Ordinary Income vs. Qualified Dividend Example
Difference between qualified dividends and REIT ordinary income.
Assumptions:
Dividend-paying stock: $10,000 invested
Dividend: $500/year
REIT: $10,000 invested
Dividend $500/year
For the stock, let’s assume that the entire $500 dividend is qualified, meaning it is taxed at the long-term capital gains tax rate of 15% for this example. In this case, you would owe $75 in taxes on the dividend ($500 x 15%).
For the REIT, let’s assume that the entire $500 dividend is ordinary income, meaning it is taxed at your marginal tax rate, which, we’ll assume, is 2 for this example5%. In this case, you would owe $125 in taxes on the dividend ($500 x 25%).
In this scenario, the tax on the REIT dividend is higher than the tax on the qualified dividend from the stock. This is because the REIT is required by law to distribute at least 90% of its taxable income to shareholders, which is generally considered ordinary income and taxed at higher rates.
2. REITs may receive a Return of Capital
REIT dividends are also subject to a different tax treatment than other types of dividends because a portion of the dividend may be classified as a return of capital(ROC).
ROC refers to a portion of the dividend paid to REIT shareholders that is considered a return of their original investment rather than taxable income.
This means that the ROC portion of the dividend is not subject to immediate taxation but does reduce the investor’s cost basis in the REIT shares they own.
There are several reasons why REITs might choose to issue a Return of Capital:
Tax efficiency
REITs are required by law to distribute at least 90% of their taxable income to shareholders each year in the form of dividends. However, not all of the income generated by a REIT is taxable. Some of it may be classified aa s return of capital, which is not subject to taxes until the investor sells their shares.
Cash flow management
REITs often use ROC to manage their cash flow. For example, a REIT may have a large capital expenditure coming up or be in the process of acquiring new propertiesThehe REIT can conserve cash to fund these activities by returning capital to investors.
Investor preferences
Some investors prefer to receive ROC because it can be more tax-efficient than receiving dividends. Additionally, ROC can help investors avoid taxes on phantom income, which can occur when a REIT distributes more than its taxable income.
Return of Capital Example:
Suppose you invested $10,000 in a REIT and received $500 in dividends during the year, of which $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 will work:
- Taxable Income: $300
- ($500 total dividends – $200 ROC)
- Cost Basis: $9,800
- (The $200 ROC reduces your cost basis from $10,00 to $9,800)
- Capital Gain: $2,200
- If you sell REIT shares later for $12,000, your capital gain is calculated using your adjusted cost basis of $9,800, not the original cost basis of $10,000
In this example, the ROC component of the dividends reduces your taxable income from the REIT dividends and lowers your capital gains tax liability when you sell the shar.es
It’s important to note that this is a simplified example. The specific tax implications of ROC and REIT dividends can vary based on individual circumstances and the tax laws in your state or country.
Note: 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.
1099-DIV Form
When you receive REIT dividends, the REIT will provide you with a 1099-DIV form at the end of the year.
This form will show the total amount of dividends you received and the portion of the dividend classified as ordinary income and return of capital.
The Bottom Line
In summary, investing in REITs can provide a steady income stream, but 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.
So, suppose you are in a high-income bracket. In that case, it may be worth considering moving to a comparable dividend-paying stock to reduce the tax on your dividends, especially if you invest 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.
