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Tax benefits and implications for REIT investors

Pacific Center Court Healthcare Research & Development in San Diego, California

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

REITs have many built-in tax efficiencies for investors. For example, they do not pay corporate income taxes, return of capital distributions are tax-deferred and REIT investors can deduct 20% of their dividends earned for the qualified business income deduction.

The income tax liability faced by REIT shareholders, however, 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, the shareholder receives this payout 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 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. 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.

Assumes $100,000 investment; 5% annualized pre-tax yield ($5,000 annualized distribution)

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.

Closing thoughts

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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Real Estate Isn’t it all just real estate?
Explore frequently asked questions about the role of public versus private real estate.
Real Estate Surprise! Retail real estate is going strong
Retail currently offers higher yields and likely less competition for investor acquisitions.

Endnotes

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.

Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Performance data shown represents past performance and does not predict or guarantee future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

Important information on risk

All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. 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.

This document provides general tax information. Nuveen is not a tax advisor. Clients should consult their professional advisors before making any tax or investment decisions. This information should not replace a client’s consultation with a professional advisor regarding their tax situation. Neither Nuveen nor any of its affiliates or their employees provide legal or tax advice. Tax rates and IRS regulations are subject to change at any time, which could materially affect the information provided herein.

Nuveen provides investment advisory services through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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