A real estate investment trust (REIT) is a popular option among investors looking for a passive income strategy that can help hedge against inflation. REITs are companies or institutions that buy and manage income-producing properties, such as hotels or retail centers. When you become a shareholder in a REIT, you receive distributions in the form of dividends.
REITs must pay shareholders a minimum of 90% of their taxable income. However, you might be wondering how these dividends will impact your tax liabilities. Generally, dividends are taxable to shareholders at the ordinary income tax rate, which is proportionate to your income. This article explains everything you need to know about how REIT dividends are taxed so you can invest with more confidence.
What Are the Different Types of REITs?
There are several different types of REITs you can invest in. Each one operates slightly differently and has a unique purpose, so you may find that one suits your financial goals better than the others.
- Equity REITs: This type of REIT focuses on buying real estate properties to generate rental income. This income provides shareholders with dividends and pays for the upkeep of the properties. This type of REIT can be further categorized as a public or private REIT.
- Mortgage REITs: An mREIT, also called a debt REIT, does not directly own real estate properties. Instead, this type of REIT invests in mortgages and mortgage-backed securities (MBS) and provides financing for mortgaging real estate properties. Investors in mREITs can focus on lending money for real estate mortgaging and earn interest from it. This can be referred to as the earnings generated by the net interest margin, or the spread between the interest earned on the mortgage loans and the cost of funding the loans. However, the spread between short-term and long-term interest rates does not tend to stay wide for long. As a result, mortgage REITs can be sensitive to interest rate fluctuations — specifically increases.
- Hybrid REITs: As its name suggests, a hybrid REIT is a combination of an equity REIT and mREIT. In this case, the REIT will buy and own real estate properties and also invest in mortgages.
How Do REITs Pay Dividends?
The U.S. Securities and Exchange Commission (SEC) requires REITs to distribute at least 90% of their yearly income to shareholders. However, some REITs may pay dividends quarterly or monthly, which is something you’ll want to consider when searching for a REIT to invest in. As a shareholder, you can receive dividends in the form of cash or additional shares. However, each REIT has specific requirements and policies, such as whether shareholders can request dividends in cash only.
For instance, publicly traded REITs must provide elective stock dividends, meaning they can distribute earnings in a mixture of cash and stock as long as at least 20% is paid in cash. This combination allows REITs to save money while still fulfilling their requirement to pay dividends.
REITs must adhere to the 90% dividend rule, but this does not necessarily mean that shareholders will receive very large payouts. REITs have various payout ratios, meaning the dividend distribution is based on the company’s net income and whether it increases or decreases. For instance, a payout ratio of 20% means the REIT pays shareholders 20% in dividends per every dollar of net income.
What Are Ordinary and Qualified REIT Dividends?
The primary difference between qualified and ordinary dividends is that shareholders can report qualified dividends to the IRS as a capital gain instead of income. By default, all dividends distributed by a REIT are considered ordinary, or non-qualified, and are taxed as ordinary income. REIT dividends can be qualified if they meet certain IRS requirements. The Jobs and Growth Tax Relief Reconciliation Act of 2003 separated dividends into these classes.
Depending on the taxpayer, reporting capital gains can result in significant tax savings that an investor would otherwise owe on the dividends. Ordinary dividends are taxed at the regular federal and state income tax rates. However, qualified dividends are taxed based on the shareholder’s individual tax bracket, which could be 0%, 15%, or 20%.
For example, if a shareholder receives $2,000 in dividends from a REIT and receives the 15% qualified dividend tax rate, they will pay $300 in taxes. For particularly high earners who are subject to net investment income tax (NIIT), the REIT dividend tax rate can go up to 23.8%.
For dividends to be considered qualified, the shareholder must hold a preferred stock for more than 60 days within a 121-day period that begins 60 days before the ex-dividend date for common stock. The ex-dividend date is the cutoff date when the stock price does not include the upcoming dividend payment.
In other words, it’s the last date you can purchase a stock and receive the next dividend. The seller receives the dividend if you purchase the stock on or after the ex-dividend date.
If the shareholder purchases the stock after this date, it is considered an ordinary dividend. In addition to this required holding period, the qualified dividend must be from the U.S. or a qualified foreign corporation.
While qualified dividends receive favorable tax treatment, some investors may view the required holding period as a disadvantage.
How Are REITs Taxed?
While you now know that ordinary dividends are taxed at the ordinary income tax rate and qualified dividends are taxed at the investor’s marginal tax rate, you should know a few other elements about REIT taxation. In some cases, all dividends distributed by a REIT may be classified as ordinary income. Aside from ordinary income, there are two ways that REIT dividends can be taxed:
- Capital gains earnings: If the REIT you invest in makes its profit from selling real estate property or assets and distributes this as a dividend, it is subject to capital gains tax. Capital gains can be taxed at short- or long-term rates. Short-term gains are taxed as ordinary income. Long-term rates are generally between 0% and 20% and depend on the investor’s income, regardless of how long a shareholder has been invested in the REIT.
- Return of capital: For dividends to be categorized as return of capital (ROC), the REIT would distribute money back to you that you previously invested. While shareholders don’t have to pay tax on ROC dividends right away, they reduce their per-share cost basis. This leads to a larger capital gains tax later if they sell their REIT shares.
REIT shareholders can view a breakdown of their dividends on the 1099-DIV form they receive for each brokerage account they have. Another essential component to consider if you wish to achieve maximum REIT tax efficiency is the qualified business income (QBI) deduction. Because REIT dividends are considered small business income, investors can potentially deduct up to 20% of their QBI on their taxes. As of 2023, the total taxable income limit to qualify for this deduction is $182,100 for filing individually and $364,200 for filing jointly.
This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary.
Learn More About Investing in REITs With 1031 Crowdfunding
Investing in REITs can help diversify your portfolio, reduce your hands-on responsibilities with actual properties, and provide tax advantages. Before choosing a REIT, consider your financial goals and weigh your options with the many different types of REITs available today. At 1031 Crowdfunding, our mission is to help investors like you learn about all the scenarios they might encounter before deciding on an investment.
As a real estate investment platform, we make it easier to view REIT investment options and equip you with the resources you need to make better-informed decisions. Register with 1031 Crowdfunding today to view all of our investment properties. We also invite you to learn more about investing in REITs and other alternative investments on our blog.
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