Understanding How REITs Are Taxed

How REITS Are Taxed
How REITS Are Taxed

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

How REITS Are TaxedHow REITS Are Taxed
How REITS Are Taxed

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

How REITS Are TaxedHow REITS Are Taxed
How REITS Are Taxed
  • 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.

Photo credit: ©iStock.com/Funtap, ©iStock.com/designer491, ©iStock.com/LaylaBird

The post Understanding How REITs Are Taxed appeared first on SmartAsset Blog.

Trending Ideas

Featured Stocks On The Move

Daily Rundown

Top 3 Stocks in Leading Sectors
  • 3 Electric Power Stocks To Buy Now

    Featured Content Hawaiian Electric Industries, Inc. (HE) Hawaiian Electric Industries, Inc. is a holding company that provides electric utility services and financial services in Hawaii. Through its subsidiaries, it supplies... Read More

  • 3 Bank Stocks To Buy Now

    Featured Content Comerica Incorporated (CMA) Comerica Incorporated is a financial services company headquartered in Dallas, Texas, offering a range of banking products and services, including commercial and retail banking, wealth... Read More

  • 3 Machinery Stocks To Buy Now

    Featured Content Alta Equipment Group Inc. (ALTG) Alta Equipment Group Inc. is an integrated equipment dealership platform in the United States, operating through three segments: Material Handling, Construction Equipment, and... Read More

  • 3 Silver Stocks To Buy Now

    Featured Content Gatos Silver, Inc. (GATO) Gatos Silver, Inc. is a precious metals mining company primarily focused on silver and zinc production. Its flagship Cerro Los Gatos mine in Mexico... Read More

  • 3 Metal Production Stocks To Buy Now

    Featured Content Century Aluminum Company (CENX) Century Aluminum Company is a primary aluminum producer, with operations that include the production of high-purity, low-carbon aluminum used in automotive, aerospace, and industrial... Read More

  • 3 Medical Drug Stocks To Buy Now

    Featured Content Teva Pharmaceutical Industries Limited (TEVA) Teva Pharmaceutical Industries Limited is a global pharmaceutical company specializing in generic and specialty medicines. The company provides a wide range of treatments... Read More

  • 3 Paper Product Stocks To Buy Now

    Featured Content AptarGroup Inc. (ATR) AptarGroup Inc. is a global leader in providing innovative dispensing and packaging solutions, serving diverse industries like beauty, personal care, and pharmaceuticals. They focus on... Read More

  • 3 Restaurant Stocks To Buy Now

    Featured Content Brinker International, Inc. (EAT) Brinker International, Inc. operates well-known restaurant brands such as Chili’s Grill & Bar and Maggiano’s Little Italy. The company is a leader in the... Read More

  • 3 Investment Brokerage Stocks To Buy Now

    Featured Content Robinhood Markets, Inc. (HOOD) Robinhood Markets, Inc. is a financial services company known for its commission-free trading platform, which allows users to trade stocks, options, cryptocurrencies, and ETFs.... Read More

  • 3 Shipping Stocks To Buy Now

    Featured Content ZIM Integrated Shipping Services Ltd. (ZIM) ZIM Integrated Shipping Services Ltd. is a global container shipping company that provides cargo transportation services worldwide. The company operates a modern... Read More

  • 3 Mining Stocks To Buy Now

    Featured Content Perpetua Resources Corp. (PPTA) Perpetua Resources Corp. is a mining company focused on the exploration and redevelopment of the Stibnite Gold Project in Idaho, which is one of... Read More

  • 3 Airline Stocks To Buy Now

    Featured Content General Electric Company (GE) General Electric Company is a global industrial conglomerate with operations spanning sectors such as aviation, healthcare, power, and renewable energy. GE is known for... Read More