REITs and their tax character

In short

You have probably heard someone mention a REIT at a party and nodded along, unsure what it actually was. I want to fix that right now, in plain words. A REIT, which stands for real estate investment trust, is a company that owns income producing real estate and lets ordinary people buy a small piece of it. You do not need to own a building to benefit from one. The tax side is where things get interesting, and a little different from what most stock investors expect. Read this once and you will be ready.

The whole of it

What it is

A friend of mine once said that buying a REIT felt like buying a slice of a shopping mall without having to deal with the plumbing. That is a pretty good description. A REIT is a company, set up under rules in the Internal Revenue Code, that pools money from many investors and puts it into real estate or real estate loans. Congress created this structure back in 1960 so that everyday people could invest in large properties. The IRS lays out the exact rules on its website at IRS.gov, and the SEC also explains the structure at Investor.gov. Those are the two primary sources worth bookmarking.

The key bargain the government struck with REITs is simple. The company pays almost no corporate income tax. In exchange, it must pay out at least the current figure, which the official source publishes each year of its taxable income to shareholders each year. That payout is called a dividend. The tax does not disappear though. It just moves to you, the investor.

How it works

I once watched a neighbor try to buy a rental property and spend six months dealing with inspections, tenants, and a leaky roof. A REIT skips all of that for you. You buy shares, just like shares of any other stock. The REIT collects rent from its buildings, or interest from its real estate loans, and then distributes most of that income to you.

Here is where the tax character comes in, and it matters a great deal. Not all REIT dividends are the same kind of income. A REIT dividend can arrive in your account wearing one of three different outfits, so to speak. The first outfit is ordinary income. The second is a return of capital, which means the company is giving you back part of your own investment, not a profit. The third is a capital gain, which happens when the REIT sells a property at a profit and passes that gain along. Each outfit gets taxed at a different rate.

Ordinary income from a REIT is taxed at your regular income tax rate. That surprises people. Most stock dividends qualify for what the tax code calls qualified dividend treatment, which carries a lower rate. REIT ordinary dividends mostly do not qualify for that treatment. They get taxed as if you earned extra wages.

There is some relief built in for individual investors. The Tax Cuts and Jobs Act of 2017 created a deduction for what the code calls pass through income, and REIT ordinary dividends often qualify. The IRS explains this under Section 199A. You may be able to deduct up to the current figure, which the official source publishes each year of your qualified REIT dividend income. That brings your effective rate down somewhat. But the exact benefit depends on your total income and situation, and a tax professional is the right person to walk through that with you.

Return of capital is its own animal. It is not taxed right away. Instead, it reduces what the tax code calls your cost basis, which is simply the price you are considered to have paid for your shares. When you sell, you pay tax on the gain, and that gain is measured from your adjusted basis. If return of capital payments bring your basis all the way to zero, further payments are taxed as capital gains right then.

Capital gain distributions come from property sales inside the REIT. These are taxed at long term capital gain rates if the REIT held the property long enough, which is currently more than the current figure, which the official source publishes each year months. Long term rates are lower than ordinary income rates for most people.

The numbers, and where to find yours

If you are holding REIT shares at tax time, your broker will send you a Form 1099 DIV. That form breaks your dividends into categories. Box 1a shows total ordinary dividends. Box 2a shows total capital gain distributions. Box 3 shows non dividend distributions, which is the tax term for return of capital. You do not have to sort this out yourself. The form does the labeling.

The exact tax rates that apply depend on your taxable income and filing status. You can find the current brackets on IRS.gov under the topic income tax rates. The current qualified dividend rate, the current ordinary income brackets, and the current long term capital gain rates are all published there each year. I will not quote a specific rate here, because those figures shift and you deserve the live number, not a stale one from a page written months ago.

The the current figure, which the official source publishes each year deduction mentioned earlier has its own income rules and phase out ranges. The IRS publishes guidance on Section 199A each year. That is the place to check your specific situation.

A worked example

Let me tell you about Rosa. Rosa earns a salary of 52,000 dollars a year and owns shares in a REIT through her brokerage account. At the end of the year, the REIT sends her a 1099 DIV showing three things. She received 600 dollars in ordinary REIT dividends. She received 100 dollars in long term capital gain distributions. She received 50 dollars as return of capital.

Rosa works through each piece one at a time. The 600 dollars in ordinary dividends gets added to her other income and taxed at her regular rate. She checks whether the Section 199A deduction applies to her, because if it does, she may deduct up to 20 percent of that 600 dollars, which would be 120 dollars, from her taxable income. She looks at IRS Form 8995, which is the form used to claim that deduction.

The 100 dollars in capital gain distributions gets taxed at the long term capital gain rate that matches her income level. That rate is lower than her ordinary rate. She checks the IRS rate tables for her filing status.

The 50 dollars in return of capital is not taxed this year at all. Rosa reduces her cost basis in the REIT shares by 50 dollars. If she originally paid 1,000 dollars for those shares, her new basis is 950 dollars. When she eventually sells, her taxable gain will be calculated from 950 dollars, not 1,000 dollars. Every step of this can be checked because the inputs are right there: 600, 100, 50, 1,000, and 950.

Where it goes wrong

I once knew a fellow who assumed REIT dividends were taxed the same as his other stock dividends. He was not happy come April. The most common mistake is expecting qualified dividend rates on REIT ordinary income. They mostly do not apply. That misunderstanding can mean an unexpected tax bill.

A second place people go wrong is forgetting to track the return of capital. Each payment chips away at your basis. If you sell years later and do not know your adjusted basis, you may overstate your gain or understate it, and both are problems. Your broker tracks this, but it is worth keeping your own record. Keep good notes.

A third issue is holding a REIT in a taxable account when a tax advantaged account might serve you better. Inside a traditional IRA or a Roth IRA, dividends grow without an immediate tax drag. The IRS rules on IRAs are at IRS.gov. I am not saying one choice is better than the other. I am saying the tax character of REIT income makes the account type worth thinking about.

Questions to answer before you leave this page

You have done good work getting this far, and a few questions are worth sitting with before you move on: Do you know which type of account holds your REIT shares, and have you thought about whether that account type matches how REIT income is taxed? Have you pulled your most recent 1099 DIV and checked boxes 1a, 2a, and 3 to see what kind of dividends you actually received last year? Do you have a current record of your adjusted cost basis in any REIT shares you own, especially if you have received return of capital payments? Have you looked at IRS Form 8995 to see whether the Section 199A deduction applies to your income level? And if any of this feels uncertain, have you spoken with a tax professional who can look at your actual numbers, not just general examples?