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 taxation rules could save you from a big 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 how mutual funds provide 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 receive Form 1099-DIV that breaks down that dividend distribution into three categories: ordinary income, capital gains, and return of capital. To complicate things, 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 part of the dividend distribution is taxed at your marginal income tax rate.
This is great for investors sitting in the lower tax brackets. It, also, eliminates 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 three ways REITs can hit you with a capital gains tax. The first is like any normal capital gain, where you buy shares of a REIT and later sell it at a higher price. You then pay capital gains tax on the profit.
The second is due to any 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. 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 or pay out the sales proceeds to shareholders. Any amount paid to shareholders is marked on Form 1099-DIV under Box 3 – Nondividend Distribution.
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 your 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. Find out more about how cost basis affects taxes.
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/share – $1 return on capital) and your total cost basis now becomes $900 on the 100 shares of XYZ REIT.
You’re not off the hook for paying taxes though. You will eventually pay capital gains tax on the difference between the selling price and your new cost basis but not until you sell those shares. Of course, there is the chance the share price drops below your new cost basis and you report a loss.
Use A Retirement Account
Here’s one last thing to consider when dealing with REITs and taxes. The tax code points to a big advantage of owning REITs inside of retirement accounts, IRAs, and other tax-advantaged accounts. The accounts offer protection from the REIT tax rules since money made is only taxed upon withdrawal, if at all.
