Your Guide to Taxes on REIT Dividends
October 11, 2022
Real estate investments can be a good hedge against inflation, but if you can't afford to buy real estate directly, you might think you're out of luck.
Fortunately, there are other ways to invest in real estate, including real estate investment trusts. But how do you pay taxes on REIT dividends, and how much will it affect your tax liabilities?
We've broken down what to expect with REIT investing and taxable REIT dividend income below.
What Is a Real Estate Investment Trust?
A real estate investment trust is an investment in a real estate company. The real estate company holds commercial real estate investments. Investors can buy company shares and earn a portion of the commercial real estate investment proceeds as interest income, dividend distributions, or capital gains.
Basic Characteristics of REITs
REITs are like mutual funds. They pool funds from multiple investors to invest in commercial real estate properties. However, REITs must distribute at least 90% of their profits back to investors.
Real estate investment companies usually invest in apartment complexes, hotels, office buildings, shopping malls, and medical facilities. They make it easier for regular investors to take advantage of the returns commercial real estate offers without large amounts of capital required.
Types of REITs
There are three REIT types, equity, mortgage, and hybrid.
- Equity REITs - These trusts by income-producing commercial real estate. They make money on the rental income earned and capital gains when the real estate company sells the property.
- Mortgage REITs - These trusts invest in the debt side of real estate, funding the loans for real estate developers to build and maintain real estate. These investments' earnings come from interest.
- Hybrid REITs - These trusts diversify and invest in equity and mortgage REITs.
What Are Taxes on REIT Dividends?
REIT dividends paid to shareholders are taxed in several ways, depending on the type of income earned. For example, the dividends earned are taxed differently than capital gains, just as they would if you invested in stocks or bonds.
The Basics of REIT Taxation
REITs are legally obligated to distribute at least 90% of their profits to shareholders. However, many REITs distribute 100% of their dividends because they can write off the distributions on their corporate taxes. This means they can avoid corporate taxes by distributing their dividends.
Taxation at the Individual-Investor Level
Individual REIT shareholders pay taxes at the individual level. So you'll pay taxes on the dividends and capital gains simultaneously. Most investors pay ordinary pay income tax rates on REIT dividends and capital gains.
Real estate companies send out 1099-DIVs to investors at the start of each year to list the dividends earned so that investors can report them on their tax returns.
It's not common, but some dividends may be qualified REIT dividends. This classification allows for a discounted tax rate.
Ordinary Income Distributions
Any dividends taxed at your ordinary income tax rate depend on your tax bracket. The more money you earn, the higher your tax bracket, aka the more taxes you pay.
Any income earned that isn't interest can also be a part of the 20% qualified business income deduction. This only pertains to earnings from regular dividends, not interest. This means you can deduct 20% of the earnings from the REIT investment on your taxes, lowering your tax burden.
Capital Gains Earnings
All REIT capital gains are taxed at the long-term capital gains tax rate. In this case, it doesn't matter how long you've had the REIT like it would with regular stock investments. Long-term capital gains tax rates are 0% - 20%, and your income determines the amount you pay—the higher your income, the higher your capital gains tax rate.
Return of Capital
If some of your REIT dividends are a return of capital, you aren't taxed on it. Return of capital means they are returning a portion (or all) of your investment. So it might lower your tax basis, which could mean higher capital gains taxes when you sell the investment.
Taxation at the Trust Level
Typically, REITs would be taxed as a corporation; however, they have special tax status, which is why they must distribute at least 90% of their profits. The other requirement they must meet to have REIT investment status is at least 75% of their profits must come from real estate and cash. In addition, at least three-quarters of their income must come from interest or rental income.
REITs don't pay corporate taxes, but any earnings they keep are taxed at corporate tax rates.
Tax Benefits of a REIT
The largest tax benefits of REIT investing are largely due to the Tax Cuts and Jobs Act that created the deduction on pass-through income. This allows REIT investors to deduct 20% of their taxable dividend income.
You don't have to itemize your deductions to get this benefit; there's no limit to it. However, it does not apply to capital gains.
Combining this benefit with the return of capital benefit, investors can reduce their income tax liability significantly by investing in REITs.
Tax on REIT Dividends FAQs
Want to learn more about taxable income and how to pay federal taxes? Check out these frequently asked questions.
Are REIT Dividends Double Taxed?
REITs are one source of corporate income that are not double taxed. This means they aren't taxed at the corporate and individual levels. This is because they don't pay corporate taxes if 90% or more of their profits are distributed to shareholders. This puts the tax burden on individual investors, not the corporation, but leaves more money for investors to earn.
How Can I Avoid Paying Tax on REITs?
Investors can't avoid paying taxes on REITs, but there are tax breaks that lower the tax liabilities of investors. First, investors can take advantage of the deduction on pass-through income, deducting 20% of their earnings immediately. Investors can also pay long-term capital gains tax rates on any capital gains, which are usually lower than ordinary income tax rates.
Do REIT Dividends Count as Income?
REIT dividends are taxed as ordinary income but are also considered qualified income so that investors can take the qualified business income tax deduction. This allows investors to deduct 20% of their income earned, reducing their tax liability.
How Are REIT Dividends Calculated?
REIT dividends are a percentage of the share price. To calculate the dividend, you can divide the amount earned by the share price.
Should You Hold REITs in an IRA?
You can hold REITs in an IRA. Even though both vehicles are tax-deferred, you can double the advantage. You won't pay taxes on the dividends earned from the REIT when you earn them. If you held them in a taxable account, you'd pay taxes at your ordinary income tax rate. In an IRA, you defer the taxes until you withdraw money; at that point, you'll be in a lower tax bracket.
Are REIT Dividends the Same as Section 199A Dividends?
Yes, dividends earned from a REIT are 199A dividends.
Can REIT Dividends Be Reinvested?
It's a fairly new option, but many REITs allow investors to reinvest their dividends. This increases the number of shares you own in the property and therefore increases your earnings.
Taxes on REIT Dividends: The Bottom Line
Real estate investment trusts offer a tax-friendly way to invest in real estate. You get the qualified business income deduction, and if you invest in an IRA, you can defer your tax liability until you withdraw the funds. So if you're worried about your taxable income, REIT investments can be a good way to increase your earnings without hurting your tax liabilities too much. Learn more by signing up and visiting our blog.
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