A Guide to REIT Taxation
By: Olivia Faucher,
A Guide to REIT Taxation offers a comprehensive explanation of what potential real estate investment trust (REIT) investors can expect to face with regard to tax obligations.
A Guide to REIT Taxation: Understanding REITs
A REIT is a company that owns, operates, or finances income-producing real estate. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.
Generally, REITs follow a simple business model: the company buys or develops properties and then leases them out to collect rent as its primary source of income. However, some REITs do not own any property, choosing instead to finance real estate transactions. These REITs generate income from the interest on the financing.
Investors can buy shares in a REIT company, the same way shares can be purchased in any other public company. Investors further can buy publicly traded REIT shares on major stock exchanges such as the NYSE or NASDAQ.
In order to be classified as a REIT, a company must meet certain criteria. One such criteria is that the company must pay out at least 90% of its taxable income to shareholders in the form of dividends. This is part of what makes REITs an attractive investment; they provide high yields and reliable dividends. However, these dividends come with unique tax obligations for shareholders.
A Guide to REIT Taxation: Why are the Taxes Unique?
It is very important for potential investors to understand the way REITs are taxed before making investment decisions. REIT taxes are unique, and the concept can be difficult to understand.
As previously mentioned, REITs are legally required to pay out at least 90% of taxable income as dividends. Given that the dividends are the taxable portion of the REIT’s income, the REIT is able to pass its tax burden to the shareholders as opposed to paying the taxes itself. In other words, the REIT company itself pays no federal income taxes, and the tax obligation falls on the shareholders.
Each dividend payout from the REIT to its shareholders is composed of a mix of funds that are acquired by the REIT from an array of sources. Profits earned by the REIT from different sources have individual tax rules. Therefore, investors do not always pay the same tax rate on the distributions received from the REIT. Rather, the payout must be dissected and categorized to determine the tax treatment.
Dividend distributions may be allocated to three categories: operating profit, capital gains and return of capital. Each of these three categories comes along with unique tax rules, which will be discussed below.
REIT dividends are also unique for the reason that they are considered ordinary, or nonqualified dividends. Nonqualified dividends are taxed at standard federal income tax rates, whereas qualified dividends are taxed at the capital gains rate. Whether or not a dividend is qualified depends on if it meets certain requirements from the IRS. Generally speaking, most dividends from US corporations are qualified. REITs are one of only a few scenarios where dividends are considered ordinary.
A Guide to REIT Taxation: The Three Scenarios
Ordinary Income/Operating Profit
Oftentimes, the dividend payouts are made up entirely of operating profit. When the company passes along operating profit to investors, it is received as ordinary income, and therefore the investor must pay his or her ordinary income tax rate on the dividend. This is the most common scenario. More often than not, shareholders must pay their income tax rate.
While operating profit makes up the bulk of REIT dividends, it is not out of the ordinary to see some portion of a REIT dividend labeled as long-term capital gain. This scenario occurs when a REIT sells a property that it has owned for over a year and the income from the sale of the property is distributed to shareholders.
Long-term capital gains are taxed at lower rates than ordinary income. The long-term capital gains rates in the United States are currently 0%, 15% or 20%, depending on the taxpayer’s income, but the rate is always lower than the corresponding tax rate for ordinary income.
The following chart breaks down the 2021 long-term capital gains rate faced by taxpayers with various income levels.
|Long Term Capital Gains Tax Rate||Taxable Income (Single)||Taxable Income (Married Filing Separately)||Taxable Income (Head of Household)||Taxable Income (Married Filing Jointly)|
|0%||Up to $40,000||Up to $40,000||Up to $54,100||Up to $80,800|
|15%||$40,401 to $445,850||$40,401 to $250,800||$54,101 to $473,750||$80,801 to $501,600|
|20%||Over $445,850||Over $250,800||Over $473,750||Over $501,600|
Return of Capital
Finally, a portion of a REIT’s distribution could be classified as a return of investor capital, or net distributions in excess of the REIT’s earnings and profits. Return of capital is not taxable immediately, and it is not taxed as ordinary income. Instead, portions of dividends that are considered return of capital are applied to reduce the shareholders’ cost basis in the stock.
For example, if an investor paid $35 per share for a REIT, and the REIT distributed $0.50 as a non-taxable return of capital, the investor’s cost basis (the price he or she originally paid per share) would be reduced to $34.50. When the shares are eventually sold, the difference between the share price and reduced tax basis is taxed as a capital gain. Therefore, distributions that include return of capital do not have an immediate impact on tax liability. However, return of capital increases an investor’s capital gains tax bill when he or she ultimately sells the REIT shares.
A Guide to REIT Taxation: An Example
The following example illustrates a fairly common scenario regarding REIT taxation.
An investor named Joseph owns shares in a REIT that pays a dividend of $3.14 per share annually. At the end of the year, management declares that 20% of the payout, or $0.63, came from depreciation of the company’s properties. This means that only $2.51 of the dividend was net profit.
In this case, only $2.51 of the $3.14 per share dividend is considered ordinary income. Joseph purchased the REIT shares more than a year ago for a price of $50 per share. As a result of this dividend, Joseph’s cost basis would decrease by $0.63 to $49.37 per share.
When Joseph later sells his shares, his long-term capital gain would be calculated on the theoretical reduced purchase of $49.37, rather than the actual price of $50 that he paid for each share.
In the meantime, Joseph will pay his income tax rate on the $2.51 portion of the dividend that is considered ordinary income.
The Bottom Line
The rules of REIT taxation are unique, given that REIT dividends are non qualified and that REIT dividend payouts may consist of money that came from a variety of sources. Shareholders can face varying tax rates depending on the situation.
The unfortunate reality for REIT shareholders is that the tax burden falls on them. However, this is no reason to look past REITs, as they can still be an attractive investment. It just means that it is important for potential investors to educate themselves about REIT taxes so they know what to expect.
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