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Tax benefits and implications for REIT investors
Real Estate Investment Trusts (REITs) have become an interesting option for income investors due to their income payouts and capital appreciation potential. Distributions from REITs can provide income flow, but the income is considered taxable in the eyes of the IRS. When the reduced tax rates are combined with an ROC tax shelter, the effective federal tax rate for REITs may be reduced considerably.
What is a Real Estate Investment Trust?
A REIT is an investment company that purchases and owns real estate for the purpose of generating current income. REITs invest in a wide scope of real estate property, such as corporate offices, warehouses, shopping malls and apartment complexes.
Generally, REITs provide income to shareholders in the form of dividends. Legally, the entity must pay out at least 90% of its taxable income as dividends. Since those dividends are actually the taxable portion of the income generated by the REIT-owned properties, the company is able to pass its tax burden to shareholders rather than pay federal taxes itself.
An overview of taxation at the individual level
The income tax liability faced by REIT shareholders can be complicated. Each distribution, or dividend payout, received by investors in taxable accounts is comprised of a combination of funds acquired by the REIT from a range of sources and categories, each with its own tax consequences.
Often, the bulk of REIT dividend payouts consists of the company’s operating profit. As a proportional owner of the REIT company, this profit is passed through to the shareholder as ordinary income and will be taxed at the investor’s marginal income tax rate as nonqualified dividends.
However, sometimes REIT dividends will include a portion of operating profit that was previously sheltered from tax due to depreciation of real estate assets. This portion of the payout is considered a nontaxable return of capital, sometimes referred to as the ROC. While it reduces the tax liability of the dividend, it also reduces the investor’s per-share cost basis. A reduction in cost basis will not impact on the tax liability of current income generated by REIT dividends, but it will increase taxes due when the REIT shares are eventually sold. For individuals with a higher taxable income in the near term, this provision may present income planning opportunities, including the ability to smooth income over multiple years.
Another portion of REIT dividends may consist of capital gains. This occurs when the company sells one of its real estate assets and realizes a profit. Whether the capital gains are deemed short-term or long-term depends on the length of time the REIT company owned that particular asset before it was sold. If the asset was held for less than one year, the shareholder’s short-term capital gains liability is the same as their marginal tax rate. If the REIT held the property for more than one year, long-term capital gains rates apply; investors in the 10% or 15% tax brackets pay no long-term capital gains taxes, while those in all but the highest income bracket will pay 15%. Shareholders who fall into the highest income tax bracket, currently 37%, will pay 20% for long-term capital gains.
Tax benefits of REITs
Current federal tax provisions allow for a 20% deduction on pass-through income through the end of 2025. Individual REIT shareholders can deduct 20% of the taxable REIT dividend income they receive (but not for dividends that qualify for the capital gains rates). There is no cap on the deduction, no wage restriction and itemized deductions are not required to receive this benefit. This provision (Section 199A qualified business income deduction) effectively lowers the federal tax rate on ordinary REIT dividends from 37% to 29.6% for a taxpayer in the highest bracket.
It is important to understand the potential benefits, timing and requirements when exploring the world of REITs. The rules of REIT taxation are unique, and shareholders can face varying tax rates depending on the scenario. As always, you should consult with your own tax, legal and investment advisors, as every individual’s situation will differ.
In this issue
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A word on risk
Responsible investing incorporates Environmental Social Governance (ESG) factors that may affect exposure to issuers, sectors, industries, limiting the type and number of investment opportunities available, which could result in excluding investments that perform well. Real estate investments are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. Please consider all risks carefully prior to investing in any particular strategy. A portfolio’s concentration in the real estate sector makes it subject to greater risk and volatility than other portfolios that are more diversified and its value may be substantially affected by economic events in the real estate industry. International investing involves risks, including risks related to foreign currency, limited liquidity particularly where the underlying asset comprises real estate, less government regulation in some jurisdictions, and the possibility of substantial volatility due to adverse political, economic or other developments.
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