Tax Treatment of REITs
Real estate investment trusts — REITs — are companies that invest in mortgages or commercial real estate. The shares of a REIT trade on the stock exchange, allowing investors to buy real estate-oriented investments in the same manner as other stocks. Real estate investment trusts are formed under special rules in the tax code, changing how investors handle distributions from REIT shares compared to other stock shares.
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REIT Rules
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To qualify for REIT status, a company must have at least 75 percent of its assets in real estate or mortgage securities. The company must also generate at least 75 percent of company revenues from these assets. A REIT does not pay corporate income tax on any earnings that are distributed to shareholders. The result is REITs tend to be high-yield stocks as the companies pay out the majority of earnings to shareholders. This is different from regular corporations that must pay income tax on all net income and dividends paid to stock investors are after-tax.
Types of Distributions
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Distributions made from a REIT to shareholders will be classified as ordinary income, capital gains or return of capital. At the end of the year, a REIT will send out an IRS Form 1099-DIV listing the amount of money an investor received in each category. The REIT approach is simpler than the reporting requirements for other types of high-yield stocks, such as master limited partnerships. Partnership companies issue forms K-1 for investors, which increase the complexity of filing income taxes. The three types of distributions from a REIT transfer directly to your annual tax return.
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Ordinary Income
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The majority of distributions from a REIT will be classified as ordinary income. This income is viewed differently than regular stock dividends for tax purposes. Dividends from an ordinary corporation will most likely qualify for a lower zero or 15 percent tax rate. REIT distributions listed as ordinary income will be taxed at the investors marginal tax rate. The individual marginal tax rate will always be higher, possibly as high as 35 percent, than tax rate an investor would pay on qualified dividends.
Capital Gans and Return of Capital
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A REIT may earn capital gains if it sells real estate properties at profitable prices. The capital gains reported on the Form 1099-DIV from a REIT will be classified as short- or long-term gains and taxed accordingly on an investor's tax return. A return of capital amount is not currently taxable to the REIT investor. The return of capital amount is used to reduce the investor's cost basis in the REIT shares. When the shares are sold, the reduced cost basis will result in a higher, taxable capital gain.
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References
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