The Basics of REIT Taxation

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The Basics of REIT Taxation

REITs are a popular solution for investors to own income-generating real estate without having to own or manage the property themselves. REITs are popular among investors due to their high yields. The trust must distribute at least 90% of its taxable income to shareholders in order to qualify as a REIT. In turn, since their profits are distributed as dividends, REITs normally do not pay corporate income taxes.

While a constant stream of payments may seem appealing, REIT dividends have particular tax implications for investors. These payments may be classified as regular income, capital gains, or capital returns, with each receiving a distinct tax treatment. We explain how REITs function and what investors should know about possible tax consequences in this post.

Basic Characteristics of REITs

A real estate investment trust (REIT) is a firm that owns, operates, or funds income-producing real estate. REITs are comparable to mutual funds in the sense that they pool cash from a large number of participants. This money is subsequently invested in real estate, such as office buildings, residential complexes, retail malls, industrial estates, hotels and resorts, and so on. REITs allow you to invest in real estate without having to deal with the headaches that come with owning property, such as dealing with leases and property care. A REIT’s units indicate proportionate ownership of the underlying assets.

REITs are widely used as investment vehicles all over the globe. REITs are accessible in 37 countries worldwide and have a market capitalisation of more than $1.7 trillion. REITs must pay at least 90% of taxable income to unitholders in the United States. This makes REITs appealing to investors looking for greater rates than those available in conventional fixed-income markets.

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Three Types of REITs

REITs generally fall into three categories:

  • Equity real estate investment trusts (REITs): These trusts invest in real estate and earn income through rent, dividends, and capital gains from property sales. This form of REIT is popular due to the triple source of income.
  • Mortgage Real Estate Investment Trusts (REITs): These trusts invest in mortgages and mortgage-backed securities. Mortgage REITs are sensitive to fluctuations in interest rates since they receive income on their assets.
  • REITs that invest in both real estate and mortgages are known as hybrid REITs.

Taxation at the Trust Level

A REIT is a tax-exempt company that would be taxed as a corporation if it did not have the unique REIT status. To be classified as a REIT, the majority of its assets and income must be derived from real estate. Furthermore, it must distribute 90% of its taxable revenue to shareholders. As a result of this requirement, REITs normally do not pay corporate income taxes, while any retained profits are taxed at the corporate level. A REIT must spend at least 75% of its assets in real estate and cash, and generate at least 75% of its gross revenue from sources like rent and mortgage interest.

Taxation to Unitholders

REIT dividend payments may be classified as regular income, capital gains, or a return on capital. All of this will be included on the 1099-DIV that REITs issue to shareholders each year. In general, the majority of the dividend is money passed down from the company’s real estate industry, and it is therefore viewed as regular income by the investor. This portion of the payout is subject to taxation at the investor’s marginal tax rate.

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The REIT may notify you that a portion of the dividend represents a capital gain or loss. This happens when a REIT sells property it has owned for at least a year. The capital gain or loss is also passed on to the investor, with gains taxed at 0%, 15%, or 20% depending on the investor’s income level in the year the gain is received.

A part of the dividend may also be classified as a nontaxable return of capital. This may occur when the REIT’s cash payouts exceed profits, such as when the corporation incurs significant depreciation charges. There are two factors to consider when it comes to capital returns. For one thing, this portion of the dividend is not taxable in the year it is paid to the unitholder. Two, it is taxed at a later date. A capital return reduces the cost basis of the unitholder. When the investor sells their units, this payout is taxed as either a long-term or short-term capital gain or loss. If the investor returns enough cash and the cost basis falls to zero, all additional non-dividend payments are taxed as a capital gain.

The part of the REIT dividend attributable to income may be subject to further preferential tax treatment under the Tax Cuts and Jobs Act (TCJA).The measure offers a new 20% deduction for pass-through company income, including eligible REIT dividends. The deduction will be phased out by the end of 2025.

Non-residents of the United States should be aware that their REIT income may be subject to a 30% withholding tax. If there is a tax treaty between the United States and the REIT holder’s place of residence, a lower rate and exemption may apply.

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Example of Unitholder Tax Calculation

An investor purchases a REIT that is now trading at $20 per unit. The REIT earns $2 per unit in revenue and distributes 90% (or $1.80) to unitholders. Earnings account for $1.20 of the payout. The remaining $0.60 is a nontaxable return of capital resulting from depreciation and other charges.

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

The Bottom Line

REITs provide unique tax benefits that may result in a consistent stream of income and greater rates than investors might receive in fixed-income markets. However, investors should understand whether these payouts are income, capital gains, or a return of capital, since each is taxed differently. Furthermore, under the TCJA, qualifying REIT dividends may be eligible for extra tax advantages. Because everyone’s tax position is unique, investors should speak with their personal financial adviser to learn how REIT dividends may affect their tax liabilities.

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