6 Great REIT Tax Advantages
September 14, 2022
Real estate investment trusts have become more popular today as more investors learn about their advantages. Not only do they make it easier to invest in real estate even if investors only have a little capital, but there are many REIT tax advantages investors can use.
If you wonder how to decrease your taxable income and want to learn other ways to invest your money, keep reading to learn more about the tax advantages of REITs.
What Is a REIT Investment
A REIT investment is an investment in an investment company that buys commercial real estate properties. They typically purchase income-producing properties that collect rent and share the profits with their shareholders.
REIT investing makes it easier for individual investors to invest in commercial real estate. Usually, this wouldn't be possible due to a lack of capital and the inability to obtain financing for the high price of commercial real estate investments.
Three Types of REITs
There are three types of REITs you can invest in, including:
- Equity REITs - These trusts buy commercial properties and operate them. They collect rent and distribute profits to shareholders from the monthly rental income and capital gains.
- Mortgage REITs - These trusts invest in the debt used to buy investment properties. Their income comes from the interest earned on the mortgage payments.
- Hybrid REITs - These trusts invest in both equity and debt investments.
The most common REIT type is an equity REIT. It pays the highest REIT dividends because of the rental income earned. When the real estate company sells the property, investors also make a prorated amount of the property's capital gains (or loss).
When investors buy shares of a REIT, they have partial ownership of the properties within the investment. REITs pool funds from many investors to invest in properties, including office buildings, apartment complexes, shopping malls, strip malls, restaurants, and medical facilities.
REIT investments allow investors to invest in real estate without owning the property themselves. As a result, it opens up more opportunities for everyday investors to take advantage of the benefits of investing in real estate, especially the tax benefits.
Most REITs are long-term investments. Before investing in one, always find out the term and liquidity. Investors can buy and sell shares on the major stock exchanges if it's a publicly traded REIT. This makes it more liquid, even though some REITs may charge an early redemption fee.
Private REITs, however, aren't as liquid. Make sure you understand these REITs before investing. Evaluate their duration so you know how long you're tying your funds up for and ensure it fits within your timeframe.
How Real Estate Investment Trusts Work
When investors purchase real estate investment trust shares, they earn a prorated amount of the property's profits. REITs must pay out at least 90% of their profits to shareholders as REIT dividends, which increases an investor's taxable income, but there are benefits.
There's no guarantee a REIT will be profitable, but if it is, the profits come from rental income, capital gains, mortgage interest, and miscellaneous income. With some REITs, investors can invest with as little as $10, making it easy to own even a small portion of real estate.
The largest benefit of investing in REITs is the dividend income. Investors earn dividend income just for investing in the asset. It's a form of passive income for investors, allowing them to take advantage of the benefits of real estate investing without a lot of capital.
Dividend income comes in many forms, including the following.
A majority of the income received from a real estate investment trust is ordinary income. Ordinary REIT dividends are the income passed to shareholders from normal business operations. This income is taxed at their ordinary tax rates.
Long-Term Capital Gains/Losses
Capital gains or losses occur when the real estate company sells an investment. They earn capital gains when they sell the property for a profit and a capital loss when they sell it for a loss. The gains and losses are long-term when the real estate company holds them for at least one year.
Return of Capital
Return of capital is the portion of the investment's operating profits that didn't incur a tax liability because of depreciation.
Tax Treatment Depends on Payment Type
The tax on REIT dividends varies based on the payment type. For example, the ordinary income tax rate is much higher than the long-term capital gains tax rates. Just as the long-term capital gains tax rates are lower than the short-term capital gains tax rates.
6 REIT Tax Advantages
Here are the top tax benefits investors earn when investing in REITs.
1. The Pass-Through Deduction
The pass-through deduction allows REIT investors to deduct up to 20% of the dividends paid from the REIT. This means REIT investors only pay taxes on 80% of the dividends earned.
Depreciation is a tax deferral method. It makes certain income earned from a REIT return of capital versus ordinary income. As we mentioned earlier, ordinary income is taxed at an investor's normal tax rate, and return of capital isn't taxed because of depreciation.
3. Qualified Business Income Deduction
Pass-through entity holders can deduct 20% of their income from REITs, allowing owners to pay federal taxes on just 80% of the dividends paid.
4. Return of Capital Non-Taxable
Return of capital dividends are not taxed. They lower your tax basis and help you reduce your taxes on dividends paid and future dividends earned.
5. Avoiding Double Taxation
REITs don't pay corporate taxes, which minimizes the risk of double taxation. Without corporate taxes owed, owners pay taxes only on the 'pass-through' income or the income they earn individually. After that, they pay taxes at their ordinary tax rate.
6. The 90% Rule
By law, REITs must pay out at least 90% of their profits as dividends to shareholders.
Real Estate Investment Trust Tax Advantage Example
Let's look at an example of taxable REIT dividend income to help you understand the tax benefits.
Let's say a REIT pays its shareholders $2,000 in dividends to each investor. However, because REITs don't pay corporate income taxes, it eliminates the $420 per shareholder that corporate taxes would cost (21%). This means shareholders get the whole $2,000 dividend shares.
Individual investors will pay taxes on their earnings, though. For example, let's say all investors are in the 24% tax bracket. This means each taxpayer would pay $480 in taxes, leaving them with $1,520 in dividends.
However, thanks to the Tax Cuts and Jobs Act, REITs are qualified business income, so investors can deduct the first 20% of their dividends. This means they pay taxes on $1,600, not $2,000.
This lowers the tax liability to $384, leaving investors with $1,616.
With the qualified business income deduction, investors could walk away with $96 more from their dividends paid.
Taxation on REITs FAQ
Check out these frequently asked questions about REIT tax advantages.
Are Real Estate Taxes Deductible?
Yes, real estate taxes are deductible, whether you pay them on your primary residence or investment property. They are a cost of doing business and are a deduction you can take on your taxes.
Are Dividends Taxed as Ordinary Income?
Most REIT dividends are taxed as ordinary income. However, there are some exceptions to the rule, such as any long-term capital gain or return of capital. Long-term capital gains are taxed at a tax rate lower than ordinary income, and the return of capital isn't taxed in the year it incurs, but the taxes are deferred.
How Are Qualified Dividends Taxed?
Qualified dividends are taxed at the same tax rate as capital gains.
Dividends vs. Capital Gains: What's the Difference?
Capital gains are profits distributed to investors, such as those earned when an investor sells an investment property. On the other hand, dividends are the monies earned from the regular operation, such as rental income.
Why Are REITs Tax Efficient?
REITs are tax efficient for many reasons. For example, they don't pay corporate income taxes, return of capital distributions are tax-deferred, and REIT investors can deduct 20% of their dividends earned for the qualified business income deduction.
Can You Lose Money With REITs?
Like any investment, you can always lose money with REITs. While historically, REITs perform well, it's essential to do your research and only invest in reputable real estate investment companies to reduce your risk of loss. Reaching out to a tax advisor for more guidance on REIT taxation and general tax advice is always helpful.
Tax Advantages of REITs: The Bottom Line
REITs are popular real estate assets for many reasons, but the REIT tax advantages are a big reason. Being able to reduce your taxable income because you invested money and earned dividends is a great reason to consider investing in REITs. Learn more by signing up and visiting our blog.
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