Dividends are the big reason investors turn to real estate investment trusts or REITs. What many people don’t know is that those dividends are not taxed like normal dividend stocks. Thanks to an overly confusing tax code, owning REITs can get complicated. Understanding the REIT tax rules could save you from a big tax charge when it’s time to file your taxes.
How Are REITs Taxed?
Real estate investment trusts were established to allow small investors access to large income producing real estate assets, much like mutual funds provided access to stocks. In doing so, REITs were giving a special tax designation used to cut their corporate taxes.
In return for the corporate tax benefits, REITs must pay out 90% of their taxable income to shareholders in the form of dividends. While the REIT tax code simplifies things from a corporate perspective, this is where it gets confusing for shareholders.
Each year, shareholders will receive a Form 1099-DIV that breaks down the dividend distribution into three categories: ordinary income, capital gains, and return of capital. To complicate things, each can be taxed at a different rate.
Ordinary Income
Since REITs are not taxed at the corporate level, dividends are taxed as ordinary income. This part of the dividend distribution is taxed at the shareholders marginal tax rate.
This is great for investors sitting in the lowest tax brackets. But can eliminate any advantage REITs have over other dividend stocks for higher income investors.
This should not be confused with any qualified dividends, which are taxed as capital gains.
Capital Gains
There are two ways shareholders can get hit with a capital gains tax. The first is due to any qualified dividends. Which are paid on the small portion of a REIT’s income that is subject to corporate tax or income from a subsidiary. In most cases this is rare.
The second is when a REIT makes a return on capital distribution.
Return of Capital
If a REIT sells an asset, like an office building, it can reinvest that money into other real estate assets or pay out the sales proceeds to shareholders. Any amount that is paid to shareholders is marked on Form 1099-DIV as a return on capital.
Return on capital is any amount that exceeds the REITs taxable income. So it’s not taxed as ordinary income. Instead it reduces the cost basis of the shares by the amount of the distribution.
For those not familiar, cost basis is just the value of the shares at the time of purchase. For example, if you bought 100 shares of the XYZ REIT at $10 per share, your cost basis would be $1,000. Later that year, when the 1099-DIV shows up in the mail, it shows a return on capital of $1 per share.
The $1 per share return on capital reduces your initial cost basis to $9 per share ($10 – $1) and your total cost basis now becomes $900 on the 100 shares of XYZ REIT.
You will pay capital gains tax on the difference between the selling price and your new cost basis, when you eventually sell those shares. Of course, there is the chance the share price drops below your cost basis and report a loss.
Use A Retirement Account
The tax code points to a big advantage of owning REITs inside of retirement accounts and other tax-sheltered accounts. Which offer protection from all these REIT tax rules. It immediately eliminates the confusion and need to break down the dividend payments by each tax rate.