How REITs Are Taxed

REITs, which stands for Real Estate Investment Trusts, are a fantastic asset to diversify your dividend-oriented investment portfolio further. They are suited for you because you can generate additional dividend income from your portfolio.

REITs are an excellent investment because they often offer higher dividend yields (above 5%) than the average indices, such as the S&P 500. Furthermore, REITs generally have to pay monthly dividends to their unitholders because of the monthly rental cash flows they generate. However, the best thing with REITs is that you don’t have to own any real estate piece to rake in the benefits of owning real estate.

Admittedly, there are a few things to consider when owning REITs. Be careful not to own REITs with dividend yields above 7% because they might be unsustainable in the long run. Another important aspect of owning REITs is how they are taxed. The more dividend income you earn from REITs, the higher the tax bracket you might fall into.

That is why this article will focus on how REITs are taxed and will shed some light on possible tax implications for investors.

Taxation of the REIT

REITs invest most of their money in real estate and generate income through rent or capital gains (after selling the property). This revenue would then be subject to the corporate tax. As REITs must pay out at least 90% of their taxable income as dividends to unitholders, they avoid paying corporate income tax, which in turn makes REITs attractive for investors looking for higher yields.

Taxation of the REIT for unitholders

It is vital to know that REIT dividends can be taxed in three different ways for you as a REIT’s unitholder. Your dividends can be ordinary income, capital gains, or return of capital. Each of the tax forms gets different treatment and, therefore, a different tax rate.

The good thing first: All public companies (REITs are public entities) must send out information to shareholders on allocating the last year’s dividends between ordinary income, capital gains, and capital return. Luckily, you don’t have to spend time to figure this out yourself, as the REIT does that for you.

The majority of dividends are taxed as ordinary income because they are operational profit passed from the REIT to the unitholder. This classification leads to taxation according to your marginal tax rate. The marginal tax rate progresses in line with your annual earnings, with the maximum tax rate being 37% (which will increase to 39.6% in 2026).

Part of the dividend might also consist of capital gains or capital losses, which occur when property, held for over a year, is sold. Otherwise, it is taxed at your marginal tax rate. The REIT will usually forward these profits or losses to you as the unitholder. Here, tax rates range between 0% and 20%, depending on your income bracket for the year that you receive the gain or loss.

The third option the REIT might report the dividend to you is as a return of capital. That means that the REIT distributed more cash than it actually earned this year, for example, through large expenses in that year. However, you don’t have to pay taxes on the dividend in the reception year, but when you eventually sell the REIT shares.

Besides, shareholders who have their dividends taxed as general income may deduct 20% for the pass-through income they receive from companies such as REITs. Considering the 20% deduction, the maximum tax rate you face on qualified REIT dividends is 29.6%.

Closing Words

REITs are an attractive asset class to invest in and provide investors with higher dividend yields than other investments that can turn into higher dividend income.

It is essential to know the three different tax options, the differences between them, and how each dividend is treated taxwise. Additionally, enjoying a 20% tax reduction on qualified REITs can have a significant impact on your tax payments.

Bear in mind that REITs should always be just a small portion of your portfolio. It should never have a more prominent role than your stock investments.

Make sure to talk to your financial advisor to determine the impact of REIT dividends and their taxation on your tax situation and how you can benefit best from holding one or multiple REITs in your portfolio.

September 26, 2020