There’s no doubt that the tax considerations of any investment are important. Yet we don’t make investment recommendations based on tax benefits alone. An investment must first make sense as part of the overall portfolio strategy.
Take real estate, for example. Investing directly in real estate has many tax and investment benefits, but only some investors are suited to be a hands-on landlord. Hiring a property manager to delegate landlord duties may be an option if the size of the investment justifies it. Another option is to invest through a Real Estate Investment Trust (REIT), an entity that owns or operates income-producing real estate and allows some of the tax benefits of real estate investing to be passed along to each shareholder.
REITs can own apartment buildings, student housing, warehouses, data centers, medical buildings, office buildings, and other types of real estate. As an investment option, they can provide important diversification for a portfolio and possibly improve the performance of a traditional stock-bond portfolio. REITs may even act as a hedge against inflation because rents could be increased as the cost of living goes up.
They’re not without risks, however. REITs usually trade on an exchange and can decrease in value. An important aspect of their return is their yield, which makes them sensitive to interest rate movements. During the calendar year 2022, for example, the real estate category average lost 25.5% compared to the S&P 500 index, which was down 18.1%.1
REIT Distributions
The distribution of income from a REIT (a REIT dividend) is taxed as ordinary income if it’s held in a taxable account. Unlike regular corporate stock, REIT dividends do not qualify for preferential tax treatment (which means in the top tax bracket, they’re taxed at 37%).
2023 Qualified Dividend Tax Rates
| Rate | Single | Married Filing Jointly | Married Filing Separately | Head of Household |
|---|---|---|---|---|
| 0% | $0 — $44,625 | $0 — $89,250 | $0 — $44,625 | $0 — $59,750 |
| 15% | $44,626 — $492,300 | $89,251 — $553,850 | $44,626 — $276,900 | $59,751 — $523,050 |
| 20% | $492,301+ | $553,851+ | $276,901+ | $523,051+ |
At the trust or company level, REITs do not receive qualified tax treatment because they typically don’t pay corporate taxes. The IRS requires that at least 90% of a REIT’s taxable earnings be distributed to shareholders as dividends. This is one reason REITs are viewed as a good source of passive income.
REIT dividends, on the other hand, received a new tax preference beginning in 2018: IRC Section 199A, which provides a 20% deduction of any qualified REIT dividends for taxpayers. This effectively results in a 20% reduction in the REIT tax rate, reducing the top rate to 29.6%.
REIT Dividends vs. Qualified Dividends
| Tax Bracket | Effective rate after 199A deduction | Qualified Dividend Rate | Difference |
|---|---|---|---|
| 10% | 8.0% | 0% | 8.0% |
| 12% | 9.6% | 0% | 9.6% |
| 22% | 18.0% | 15% | 2.6% |
| 24% | 19.2% | 15% | 4.2% |
| 33% | 26.4% | 15% | 11.4% |
| 35% | 28.0% | 15% | 13.0% |
| 37% | 29.6% | 20% | 9.6% |
Unfortunately, this provision is set to expire on December 31, 2025, unless Congress extends it.
Return of Capital
By investing in REITs, you may also be able to take advantage of tax deductions for depreciation and amortization. A portion of the REIT distribution could be classified as a return of capital (ROC). ROC is not taxable in the year it’s received, but it does reduce your cost basis for that position (the asset’s purchase price). You will need to keep track of ROC distributions each year, which will impact the ultimate capital gain on the position when it is sold.
The downside, however, is that reducing the cost basis can trigger a larger capital gain if you sell the REIT later. One solution is to employ an aggressive tax-loss harvesting strategy with other money in your portfolio, booking the losses and using them to offset the capital gain from selling the REIT. The IRS allows you to offset long-term capital gains with long-term capital losses. Unused losses in the current year can be carried forward indefinitely on your federal tax return (state rules vary). Return of capital can be a significant tax advantage for REIT investors.
Tax Reporting of REIT Distributions
REIT owners receive Form 1099-DIV, Dividends and Distributions from their account custodian to report their qualified REIT income. (The information appears on Schedule B and carries directly onto Form 1040 of your tax return.)
REIT distributions fall into three separate categories:
- Ordinary income: Your REIT dividends are taxed as ordinary income according to your marginal tax rate. (There are two parts to “Box 1” of the 1099-DIV, one for ordinary dividends and another for qualified dividends, which are taxed at a lower rate.)
- Capital gains: When a REIT sells a property held for at least one year, the gains are taxed at 0, 15, or 20 percent, depending on your tax bracket. Capital gains received from a REIT are always taxed as long-term gains regardless of whether you’ve held the position for 12 months. This is shown in Box 2a of the 1099-DIV.
- Return of capital: These distributions are not taxed and can be used to reduce the investment’s cost basis. They are reported on Box 3 of your 1099-DIV.
What is the best location for REITs?
REITs tend to have above-average dividend yields and are taxed at higher rates than qualified dividends. As we’ve seen, the tax reporting can also be complex. This makes them a great type of dividend investment to hold in tax-advantaged retirement accounts like traditional IRAs, Roth IRAs, and 401(k)s. In this scenario, you wouldn’t need to keep track of the cost basis from ROC.
It’s also okay to own REITs in taxable accounts. However, it certainly makes more sense to hold them in a tax-deferred IRA due to the complex REIT taxation rules. While distributions from IRAs and 401(k)s are both 100% taxable as ordinary income, owning REITs in taxable accounts may allow you to take advantage of the return of capital and 199A rate reductions, which could reduce the taxes on distributions.
Taxes aren’t the only investment consideration with REITs, but they’re something to pay attention to. There are many types of REITs and different kinds of ownership, such as publicly traded REITs vs. non-traded REITs. Working with a financial adviser who can help you navigate the choices is essential.
Insights:
- The IRS requires at least 90% of a REIT’s taxable earnings to be distributed to shareholders to avoid corporate taxation.
- Since 2018, REITs have been given a new tax preference: the IRC Section 199A deduction that provides a 20% deduction of any qualified REIT dividends.
- REITs may also distribute return of capital which is not taxable but does reduce the owner’s cost basis in the security.
- Source: Steele Mutual Fund Expert.
