For those just getting their beaks wet with REIT investing, we have some news: Uncle Sam wants his crack of the nest egg.
A basic understanding of REIT tax mechanics can help trim the tab and your nest egg in tip top shape.
REIT income taxation 101
When tax season rolls around, REITs send shareholders a 1099-DIV form summarizing the growth of the principal investment as well as the cumulative dividend payouts for that tax year.
In most cases, REIT investors simply need to input the information from the 1099-DIV form into TurboTax, H&R Block, FreeTaxUSA, or other preferred self-filing software.
With the exception of the 1099-DIV form, REITs generally do not require any additional paperwork.
In the eyes of the IRS, there are two components to REIT taxation:
- Capital gains or losses (resulting from the sale of an REIT stake)
Here, we’ll break down how they are handled and what variables impact taxation rates.
On the backend: REITs and corporate tax
REITs are granted favorable tax status if they meet the following conditions:
- 90% of their income is distributed to shareholders in the form of dividend payments
- 75% of income is generated from real estate activities
In return, they are considered “pass through” corporations (like LLCs and S-corporations) and exempt from paying corporate taxes.
Consider that other types of dividend distributions, like those that come from profit-sharing stocks, are first taxed at the corporate level.
This bodes well for REIT shareholders – there’s more pie to go around.
REIT dividend distribution taxation
However, that pie isn’t getting off scot free. Though they weren’t taxed on the corporate level, they are taxed on the individual (shareholder) level.
REIT dividend distributions fall into one of three taxation buckets:
- Ordinary income, marginal rate
- Long-term capital gains
- Return on capital
Here, we’ll go over each category and how to know where your 2020 REIT dividend payments fall.
The U.S. tax code classifies dividend distributions of any variety as either ‘qualified’ or ‘ordinary.’
Because the investor receives the untaxed REIT payment, dividend distributions are considered ‘ordinary’ or ‘non-qualified.’
In the majority of cases, REIT dividend distributions are categorized as ordinary income – the same bucket as the salary your employer pays you, bonuses,
commissions, tips, income from your own business, etc.
In 2017, Congress passed the Tax Cuts and Jobs Act, which included an advantageous tax perk for REIT investors.
REIT dividend distributions were granted a 20% deduction, which lowers the taxable amount.
For example: If an investor received $10,000 in REIT dividend distributions in 2020, only $8,000 of it is added to their taxable income for the year.
Ultimately, the rate of taxation of your REIT distributions will depend on your total income for that tax year. That figure is subject to the federal government’s progressive income taxation rate, outlined in the table below.
2021 Federal Income Tax Brackets
|Rate||Single Individuals||Married Individuals Filing Joint Returns||
Heads of Household
|10%||Up to $9,950||Up to $19,990||Up to $14,200|
|12%||$9,951 to $40,525||$19,901 to $81,050||$14,201 to $54,200|
|22%||$40,526 to $86,375||$81,051 to $172,250||$54,201 to $86,350|
|24%||$86,376 to $164,925||$172,251 to $329,850||$86,351 to $164,900|
|32%||$164,926 to $209,425||$329,851 to $418,850||$164,901 to $209,400|
|35%||$209,426 to $523,600||$418,851 to $628,300||$209,401 to $523,600|
The tax rate of your dividend distributions will depend on your total net income for that calendar year.
Long-term capital gains
While the majority of REIT income is taxed as ordinary income tax, some of the dividend distributions may instead be subject to a capital gains tax.
In most cases, capital gains tax rates are preferable to income tax rates because they are usually lower.
Dividend distributions that qualify for the preferred capital gains tax are the product of incidental events.
Most commonly, it is income generated from the sale of a property in the REIT’s portfolio that is in turn distributed to shareholders> The only condition for the proceeds from a sale to qualify for long-term capital gains tax is that it must have been held in REIT’s portfolio for at least a year.
Not to worry – the 1099-DIV form will parse out how much of your total distributions will be subject to ordinary income tax (Box 1) versus capital gains tax (Box 2).
Return of capital
Lastly, a portion of your total REIT distribution income may be classified as ‘return of capital,’ which you will find in Box 3 of your 1099-DIV document.
The good news is that any funds that fall into Box 3 are tax free (woo hoo!) – for now.
In short, the REIT is returning a portion of investors’ principal investment.
Because you already shelled out taxes on your initial investment, you won’t need to pay taxes again when that capital is returned to you.
However, return on capital income could have tax implications downstream.
When the REIT returns a piece of your original investment in the form of distributions, you aren’t selling your shares in the REIT.
Instead, your cost-per-share is reduced.
- You bought 100 shares of HappyNest’s REIT at $100 per share.
- In a dividend distribution, HappyNest distributes $5 per share return on capital.
- You would see $500 ($5 x 100 shares) in Box 3 of your 1099-DIV
- After, your cost per HappyNest share is $95.
- A few years from now, you sell your HappyNest holdings at $200 dollars per share.
- Because of that $5 return of capital distribution, your profit on the sale would be $105 dollars per share ($200-$95=$105).
The profit from the sale of REIT shares is subject to taxes in the year of their sale.
Reinvested dividend taxation
If you are reinvesting your REIT dividend distribution, the distribution is still considered taxable income.
Principal investment taxation
As far as your core investment, no tax applies while it remains invested in the REIT.
It only has tax implications if you sell your stake.
If you liquidated out of a REIT stake this year (i.e., sold you shares), there are a few more tax considerations.
If the shares you sold gained value while you were holding them, the profits (sale value – principal investment) are taxable.
The rate of taxation depends on how long you held your REIT stake.
Short-term capital gains tax
If you held the shares for less than a year, then any profits from the sale should be considered ordinary income and will be based on your income tax bracket.
Long-term capital gains tax
There is a tax incentive to hold your REIT investment for at least a year.
If you do, any profits from the sale of your shares will be subject to the long-term capital gains tax, which is generally lower than income tax rates.
2021 capital gain tax rates
2020 proved to be a difficult year for certain sectors of the real estate market, especially the commercial office and retail sectors.
That means investors may have sold out of their REIT stake at a loss. Filers can subtract up to $3,000 worth of capital losses from their taxable income per year.
However, $3,000 is the maximum capital loss deduction allowed per year against your total earned income. Losses that exceed $3,000 can be deducted from future tax filings.
A lucrative investment
Taxes might not be great dinner conversation, but they are the tail-side of the wealth-growing coin.
Tax efficiency can have big implications on your bottom line. Working with a tax professional to better understand how taxes work can further your financial education and optimize your tax bill.
And there’s no better investment than that of your financial knowledge.