The Basics of REIT Taxation

Real estate investment trusts (REITs) are a popular way for investors to own income-generating real estate without having to buy or manage property. Investors like REITs for their generous income streams. To qualify as a REIT, the trust must distribute at least 90% of its taxable income to shareholders. In turn, REITs typically don't pay any corporate income taxes because their earnings have been passed along as dividend payments.

While a steady flow of payments may sound enticing, REIT dividends come with unique tax consequences for investors. These payments can constitute ordinary income, capital gains, or a return of capital—each of which receives different tax treatment. Below, we explain how REITs work and what investors should know about the potential tax implications.

Basic Characteristics of REITs

A REIT is a company that owns, operates or finances income-producing real estate. They are similar to mutual funds, in that REITs pool together capital from a large number of investors. This money is then used to invest in property such as office buildings, apartment complexes, shopping malls, industrial estates, hotels and resorts etc. REITs make it possible to invest in real estate without the hassles that come with owning property, such dealing with leases and property upkeep. Each unit in a REIT represents proportional ownership of the underlying properties.

REITs are popular investment vehicles around the world. Globally, REITs are available in as many as 37 countries and have surpassed $1.7 trillion in market capitalization. In the United States, REITs are required to pay at least 90% of taxable income to unitholders. This makes REITs attractive to investors seeking higher yields than what can be earned in traditional fixed-income markets.

Three Types of REITs

REITs generally fall into three categories:

• Equity REITs: These trusts invest in real estate and derive income from rent, dividends and capital gains from property sales. The triple source of income makes this type of REIT popular.
• Mortgage REITs: These trusts invest in mortgages and mortgage backed securities. Because mortgage REITs earn interest from their investments, they are sensitive to interest rates changes. 
• Hybrid REITs: These REITs invest in both real estate and mortgages.

Taxation at the Trust Level

A REIT is an entity that would be taxed as a corporation were it not for its special REIT status. To meet the definition of a REIT, the bulk of its assets and income must come from real estate. In addition, it must pay 90% of its taxable income to shareholders. This requirement means REITs typically don't pay corporate income taxes, though any retained earnings would be taxed at the corporate level. A REIT must invest at least 75% of its assets in real estate and cash, and obtain at least 75% of gross income from sources such as rent and mortgage interest.

Taxation to Unitholders

The dividend payments that REIT investors receive can constitute ordinary income, capital gains, or a return on capital. This will all be broken down on the 1099-DIV that REITs send to shareholders each year. Generally speaking, the bulk of the dividend is income passed along from the company's real estate business and is therefore treated as ordinary income to the investor. This part of the dividend is taxed according to the investor's marginal tax rate.

The REIT may inform you that part of the dividend is a capital gain or loss. This occurs when the REIT sells property it has held for at least one year. The capital gain or loss is also passed along to the investor, with gains taxed at 0%, 15% or 20%, depending on the investor's income level for the year in which the gain is received.

In addition, a portion of the dividend may be listed as a nontaxable return of capital. This can happen when the REIT's cash distributions exceed earnings, for example, when the company takes large depreciation expenses. There are two things to note about a return of capital. One, this part of the dividend is not taxable in the year in which it is paid to the unitholder. Two, it is taxed later. A return of capital lowers the unitholder's cost basis. This payment is taxed as either a long- or short-term capital gain or loss when the investor sells their units. If enough capital is returned to the investor and the cost basis falls to zero, any further non-dividend distributions are taxed as a capital gain.

The portion of the REIT dividend that is attributable to income may receive further preferential tax treatment under the Tax Cuts and Jobs Act (TCJA). The act gives a new 20% deduction for pass-through business income, which includes qualified REIT dividends. The deduction expires at the end of 2025.

Non-U.S. residents should note that their REIT income could be subject to a 30% withholding tax. A reduced rate and exemption may apply if a tax treaty exists between the U.S. and the REIT holder's country of residence.

Example of Unitholder Tax Calculation

An investor buys a REIT currently trading at $20 per unit. The REIT generates $2 per unit from operations and distributes 90% (or $1.80) to unitholders. Of this, $1.20 of the dividend comes from earnings. The remaining $0.60 comes from depreciation and other expenses and is considered a nontaxable return of capital.

The investor would pay ordinary income taxes on the $1.20 in the year in which it was received. Meanwhile, the investor's cost basis is reduced by $0.60 to $19.40 per share. As stated previously, this reduction in basis will be taxed as a either long- or short-term gain or loss when the units are sold.

The Bottom Line

REITs provide unique tax advantages that can translate into a steady stream of income for investors and higher yields than what they might earn in fixed-income markets. However, investors should know whether these payments are in the form of income, capital gains or a return of capital, as each is treated differently at tax time. Furthermore, qualified REIT dividends may enjoy additional tax breaks under TCJA. As each person's tax situation is different, investors should consult with their own financial advisor to understand how REIT dividends will impact their tax obligations.