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Understanding the REIT Taxation Rules

CEO Khai Intela
Dividends are the reason why many investors turn to real estate investment trusts (REITs). However, what most people don't realize is that these dividends are not taxed in the same way as normal dividend stocks....

REIT Tax Rules

Dividends are the reason why many investors turn to real estate investment trusts (REITs). However, what most people don't realize is that these dividends are not taxed in the same way as normal dividend stocks. The complex tax code surrounding REITs can make things complicated. Therefore, understanding the REIT taxation rules is crucial to avoid any unexpected charges when it comes time to file your taxes.

How Are REITs Taxed?

Real estate investment trusts were established to provide small investors with access to large income-producing real estate assets, similar to how mutual funds provide access to stocks. As a result, REITs were given a special tax designation to reduce their corporate taxes.

In exchange for the corporate tax benefits, REITs are required to distribute 90% of their taxable income to shareholders in the form of dividends. While this tax code simplifies things from a corporate perspective, it can be confusing for shareholders.

Each year, shareholders receive Form 1099-DIV, which breaks down the dividend distribution into three categories: ordinary income, capital gains, and return of capital. To make things more complicated, each distribution is taxed at a different rate.

Ordinary Income

Since REITs are not taxed at the corporate level, dividends are taxed as ordinary income. Ordinary REIT dividend payments are marked on the 1099-DIV in Box 1a - Total Ordinary Dividends. This portion of the dividend distribution is taxed at your marginal income tax rate.

This is beneficial for investors in lower tax brackets and eliminates any advantage REITs may have over other dividend stocks for higher income investors.

It is important to note that ordinary income should not be confused with qualified dividends, which are taxed as capital gains.

Capital Gains

There are three ways in which REITs can subject you to capital gains tax. The first is similar to any normal capital gain, where you buy shares of a REIT and sell them at a higher price. In this case, you would pay capital gains tax on the profit.

The second way is through qualified dividends (Box 1b on 1099-DIV), which are paid on the small portion of a REIT's income that is subject to corporate tax or income from a subsidiary. However, this is rare in most cases.

The third way is when a REIT makes a return on capital distribution.

Return of Capital

If a REIT sells an asset, such as an office building, it can reinvest that money into other real estate or distribute the sales proceeds to shareholders. Any amount paid to shareholders is marked on Form 1099-DIV under Box 3 - Nondividend Distribution.

Return on capital refers to any amount that exceeds the REIT's taxable income. It is not taxed as ordinary income but instead reduces the cost basis of your shares by the amount of the distribution.

Cost basis is the value of the shares at the time of purchase. For example, if you bought 100 shares of XYZ REIT at $10 per share, your cost basis would be $1,000. Return on capital would reduce your initial cost basis to $9 per share, making your total cost basis $900 for the 100 shares of XYZ REIT.

While you may not immediately have to pay taxes on the return on capital, you will eventually pay capital gains tax when you sell those shares based on the difference between the selling price and your new cost basis. However, if the share price drops below your new cost basis, you may report a loss.

Use a Retirement Account

One last thing to consider when it comes to REITs and taxes is the advantage of owning REITs inside retirement accounts, IRAs, and other tax-advantaged accounts. These accounts offer protection from the REIT tax rules since any money made is only taxed upon withdrawal, if at all.

By understanding the complexities of REIT taxation rules, investors can make informed decisions and potentially save themselves from any unexpected tax liabilities. It is essential to consult with a qualified tax professional to ensure compliance with the relevant tax laws and regulations.