What to Know When Investing in REITs - Rodgers & Associates (2024)

There’s no doubt that the tax consid­er­a­tions of any investment are important. Yet we don’t make investment recom­men­da­tions based on tax benefits alone. An investment must first make sense as part of the overall portfolio strategy.

Take real estate, for example. Investing directly in real estate has many tax and investment benefits, but only some investors are suited to be ahands-on landlord. Hiring aproperty manager to delegate landlord duties may be an option if the size of the investment justifies it. Another option is to invest through aReal Estate Investment Trust (REIT), an entity that owns or operates income-producing real estate and allows some of the tax benefits of real estate investing to be passed along to each shareholder.

REITs can own apartment buildings, student housing, warehouses, data centers, medical buildings, office buildings, and other types of real estate. As an investment option, they can provide important diver­si­fi­cation for aportfolio and possibly improve the perfor­mance of atradi­tional stock-bond portfolio. REITs may even act as ahedge against inflation because rents could be increased as the cost of living goesup.

They’re not without risks, however. REITs usually trade on an exchange and can decrease in value. An important aspect of their return is their yield, which makes them sensitive to interest rate movements. During the calendar year 2022, for example, the real estate category average lost 25.5% compared to the S&P 500 index, which was down 18.1%.¹

REIT Distributions

The distri­b­ution of income from aREIT (a REIT dividend) is taxed as ordinary income if it’s held in ataxable account. Unlike regular corporate stock, REIT dividends do not qualify for prefer­ential tax treatment (which means in the top tax bracket, they’re taxed at37%).

2023 Qualified Dividend TaxRates

At the trust or company level, REITs do not receive qualified tax treatment because they typically don’t pay corporate taxes. The IRS requires that at least 90% of aREIT’s taxable earnings be distributed to share­holders as dividends. This is one reason REITs are viewed as agood source of passiveincome.

REIT dividends, on the other hand, received anew tax preference beginning in 2018: IRC Section 199A, which provides a20% deduction of any qualified REIT dividends for taxpayers. This effec­tively results in a20% reduction in the REIT tax rate, reducing the top rate to 29.6%.

REIT Dividends vs. Qualified Dividends

Unfor­tu­nately, this provision is set to expire on December 31, 2025, unless Congress extendsit.

Return ofCapital

By investing in REITs, you may also be able to take advantage of tax deduc­tions for depre­ci­ation and amorti­zation. Aportion of the REIT distri­b­ution could be classified as areturn of capital (ROC). ROC is not taxable in the year it’s received, but it does reduce your cost basis for that position (the asset’s purchase price). You will need to keep track of ROC distri­b­u­tions each year, which will impact the ultimate capital gain on the position when it issold.

The downside, however, is that reducing the cost basis can trigger alarger capital gain if you sell the REIT later. One solution is to employ an aggressive tax-loss harvesting strategy with other money in your portfolio, booking the losses and using them to offset the capital gain from selling the REIT. The IRS allows you to offset long-term capital gains with long-term capital losses. Unused losses in the current year can be carried forward indef­i­nitely on your federal tax return (state rules vary). Return of capital can be asignif­icant tax advantage for REITinvestors.

Tax Reporting of REIT Distributions

REIT owners receive Form 1099-DIV, Dividends and Distri­b­u­tions from their account custodian to report their qualified REIT income. (The infor­mation appears on Schedule Band carries directly onto Form 1040 of your taxreturn.)

REIT distri­b­u­tions fall into three separate categories:

• Ordinary income: Your REIT dividends are taxed as ordinary income according to your marginal tax rate. (There are two parts to “Box 1” of the 1099-DIV, one for ordinary dividends and another for qualified dividends, which are taxed at alower rate.)
• Capital gains: When aREIT sells aproperty held for at least one year, the gains are taxed at 0, 15, or 20 percent, depending on your tax bracket. Capital gains received from aREIT are always taxed as long-term gains regardless of whether you’ve held the position for 12 months. This is shown in Box 2a of the1099-DIV.
• Return of capital: These distri­b­u­tions are not taxed and can be used to reduce the investment’s cost basis. They are reported on Box 3of your1099-DIV.

What is the best location forREITs?

REITs tend to have above-average dividend yields and are taxed at higher rates than qualified dividends. As we’ve seen, the tax reporting can also be complex. This makes them agreat type of dividend investment to hold in tax-advantaged retirement accounts like tradi­tional IRAs, Roth IRAs, and 401(k)s. In this scenario, you wouldn’t need to keep track of the cost basis fromROC.

It’s also okay to own REITs in taxable accounts. However, it certainly makes more sense to hold them in atax-deferred IRA due to the complex REIT taxation rules. While distri­b­u­tions from IRAs and 401(k)s are both 100% taxable as ordinary income, owning REITs in taxable accounts may allow you to take advantage of the return of capital and 199A rate reduc­tions, which could reduce the taxes on distributions.

Taxes aren’t the only investment consid­er­ation with REITs, but they’re something to pay attention to. There are many types of REITs and different kinds of ownership, such as publicly traded REITs vs. non-traded REITs. Working with afinancial adviser who can help you navigate the choices isessential.

Insights:

• The IRS requires at least 90% of aREIT’s taxable earnings to be distributed to share­holders to avoid corporate taxation.
• Since 2018, REITs have been given anew tax preference: the IRC Section 199A deduction that provides a20% deduction of any qualified REITdividends.
• REITs may also distribute return of capital which is not taxable but does reduce the owner’s cost basis in thesecurity.