Real estate investment trusts, or REITs, can be a great addition to a well-diversified portfolio. These investments offer a solution to those looking to benefit from real estate assets. However, they also come with their own unique tax implications. Here’s a look at how REITs are taxed and what you can expect to owe Uncle Sam if you own these investments. Consider working with a financial advisor as you prepare your taxes on REIT dividends.
How REITs Are Taxed at the Corporate Level
There are many benefits of adding REITs to your investment portfolio. One such benefit is that REITs do not typically pay corporate taxes. This can affect how individual investors are responsible for taxes.
Since the REIT does not pay corporate taxes, it has more profit to disburse to investors. In fact, the IRS requires that at least 90% of a REIT’s taxable earnings are to be distributed to shareholders in the form of dividends. This is one primary reason why REITs are viewed as a strong investment and source of passive income.
Ordinary vs. Qualified REIT Dividend Taxes
The dividends distributed to investors by a REIT can either be considered ordinary income or qualified income. The taxes that you as an investor will pay on those dividends depends on its income class. This can be ordinary dividends (taxed at your ordinary tax rate) or qualified dividends (taxed at a lower rate).
Qualified dividends are those offered by eligible companies, first and foremost. These are usually domestic corporations, though some foreign corporations may also qualify. If the dividends you receive are from an eligible company, however, they still won’t be counted as qualified income unless you have held the investment for a specific period of time.
This ownership requirement, also known as a holding period, means that you must have owned the investment for more than 60 days out of the previous 121-day period, which begins 60 days prior to the ex-dividend date. While the IRS jargon is a bit confusing, just know that you will need to have held the investment for at least two months in order for the dividends to count as qualified income.
If your dividends count as qualified income, they will be taxed at either 0%, 15% or 20%. Your rate depends on your overall adjusted gross income (AGI). Just note that most REITs won’t fall into the qualified category.
Anything else – such as dividends provided by a non-qualifying company or dividends from an investment that you haven’t owned for long enough – is considered ordinary income. These ordinary dividends are taxed alongside your remaining income, at the tax rate for which your overall income qualifies.
REITs and Capital Gains Taxes
There are two instances when your REIT will encounter capital gains taxes. First, a capital gains qualifying event occurs if the REIT sells property that it has owned and managed. If that property is sold for a profit, the gain will be subject to capital gains taxes. Any distribution of this profit to investors will either be considered short-term or long-term capital appreciation.
Short-term capital gains are the result of a property that was owned for less than a year and are taxed at the shareholder’s marginal rate. If the property was owned for a year or more, though, it is considered a long-term gain and is taxed at either 0%, 15% or 20%.
Second, your REIT can also provide you with income in the form of share growth. When you go to sell appreciated REIT shares, however, this growth will be subject to capital gains taxes. Currently, the maximum long-term capital gains tax rate is 20%; the rate shareholders will pay depends on how long they owned the REIT and their marginal tax rate.
REITs and Return of Capital
Some REIT distributions are considered return of capital. This occurs when the REIT returns a portion of the shareholder’s initial investment, or capital, as a scheduled distribution.
Since this effectively returns some of your invested money back to you, a return of capital distribution is not a taxable event. That can be beneficial for your tax bill now, but may result in higher taxes down the line as it also reduces your cost basis in the REIT. This means that when (and if) you eventually sell your shares of the REIT, it will result in a higher capital gain than if your capital had not been returned to you previously.
Bottom Line
REITs are considered a valuable addition to most portfolios, offering steady growth and a source of passive income. Since they operate as a pass-through tax entity, investors may enjoy higher returns and a more beneficial tax situation. There are still taxes to consider, however. These may be considered ordinary income, qualified dividends or capital gains, depending on how and when it’s received.
Tips on REIT Taxes
- Taxes on investments can be confusing, but a financial advisor can shed light on and offer guidance about taxes so you don’t pay more than you need to. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- It can pay to learn ahead of time what your tax situation will look like over the next year. Try using a free federal income tax calculator or capital gains tax calculator.
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