A real estate investment trust, or REIT, passes income from its holdings to its investors as dividends. The income generated from a REIT falls into different categories with its own tax rules.
For deriving taxation, it needs to invest at least 75% of its assets in real estate. In addition, REITs must have at least 100 shareholders. And no five shareholders can control a majority of a REIT’s outstanding shares.
The most important REIT requirement is that it must distribute at least 90% of its taxable income to shareholders. Most REITs end up paying out all of it. It’s great but also it has some tax implications which you need to know.
Read Lilypads’ blog on state income tax benefits of REITs here.
REIT Tax structure at the Individual-Investor level
As an investor in a REIT, this taxation setup offers you the advantage of only paying taxes on dividends and capital gains once. Most dividends are taxed at your ordinary-income tax rate. When paying taxes on REITs, you’ll receive FORM 1099-DIV from any REITs you’re invested in during tax season. This form will have a breakdown of dividends and this breakdown will include regular income distributions as well as capital gains earnings. And REIT dividend taxes have three categories :
1. Ordinary Income Distributions:
For ordinary income distributions, the rates are taxed on your income and tax bracket. For example, if your taxable income was $50,000 in 2021, you must pay taxes at a rate of 22% for ordinary income distributions paid that year. You are also eligible to deduct up to 20% of qualified business income from your taxes on the portion of qualified REIT dividends that qualify as ordinary income and not interest. It’s the money you make from collecting rents or mortgage payments.
2. Capital gains earnings:
There are short-term and long-term capital gains tax rates. When it comes to REITs, term capital gains are taxed at long-term rates regardless of how long you’ve had money invested in a REIT. Long-term capital gains tax rates range from 0% to 20%.
- Return of Capital:
In real estate investing dividends fall under the category of return of capital. This means the REIT dividends are basically giving you back some of the money you invested. You won’t pay taxes on these dividends now, but they reduce your cost basis, and you may have a potentially larger capital gains tax to pay later when you sell your REIT shares.
REIT structure: How are REITs taxed?
There are full tax benefits in real estate investment trusts that are not available in many other asset classes. Here is a look at just a few of them:
1. The Pass-through Deductions:
Thanks to the 2017 Tax Cuts and Jobs Act, sweeping new changes to the tax code allow for a lucrative tax benefit for REIT investors: the pass-through deduction. The pass-through deduction allows REIT investors to deduct up to 20% of their dividends. Investors in the top tax bracket can potentially see their tax bill for dividends go from 37% to 29.6%. That means that you’re saving up to $740 annually on $10,000 of REIT dividends.
2. Avoiding Double Taxation:
REITs, distribute earnings to investors in the form of dividends. Unlike many companies, however, REIT incomes are not taxed at the corporate level. That means REITs avoid the dreaded “double-taxation” of corporate tax and personal income tax. Instead, corporate taxes do not affect REIT income so their investors have to pay taxes just once. This is the major tax advantage that investors value REITs over many other dividend-paying companies.
Another advantage that payroll taxes have bestowed upon real estate investors is the concept of depreciation. It basically serves as a tax deferral mechanism. The greater the amount of depreciation expense, the more likely it is that the taxable portion of the REIT dividends will decrease.
Depreciation works to effectively reclassify certain dividends from “ordinary income” to “return of capital”. It minimizes the amount of dividend income that is taxed at the personal rate while maximizing the amount of income that is taxed at a rate of 25%.
4. The 90% rule:
REITs have been given special tax deductions which add spice to everyday plating which gives access to a diversified portfolio of real estate without the large capital investment required to actually acquire such a portfolio. In return, the tax code holds REITs to certain standards. One such standard is the 90% rule, which requires REITs to pay out at least 90% of their earnings as dividends.
The 90% rule was created to help the investors to enjoy passive income from a diversified portfolio of real estate. The 90% rule is a check on executive management which may seek to reinvest earnings rather than distribute them directly to shareholders.
How to avoid the complicated and expensive tax on REITs dividends?
REITs are a popular retirement investment plan. You don’t have to worry about paying dividend taxes yearly. And you don’t need to worry about complicated capital gains taxes when you sell shares of a REIT. If you own REITs in tax-deferred accounts you won’t pay taxes until you withdraw money from your account.
Funds in these accounts can continue to grow tax-deferred as long as they’re in the account. And they become taxable income when you withdraw the money is eventually. And also the contributions to these accounts are tax-deductible.
On the other hand, if you own REITs through an after-tax account like a Roth IRA, you won’t ever have to pay taxes on your REIT dividends and capital gains, even when you withdraw from the account. The drawback is that contributing to a Roth account doesn’t get you immediate tax benefits. But that’s a small price to pay to avoid future taxation on qualified withdrawals.
Before investing in REITs, it’s important to understand how REIT tax structure. With a REIT, you’ll often receive dividends the whole year, which you’ll need to pay taxes on. You will be sent a breakdown of the income you have earned through any dividend distributions you took as well as capital gains, making it easy to file your tax return. You will also receive a 20% qualified business income deduction on the part of the dividends that are categorized as ordinary income, which will help you save a little. So, it’s better to work with an accountant to better understand exactly how much you’ll pay in taxes when you invest in a REIT.