A real estate investment trust, or REIT, is essentially a mutual fund for real estate. As the name suggests, the trust invests in real estate related investments. Investors buy shares in the trust, and the REIT passes income from its holdings to those investors. Because real estate generates different kinds of cash flow, the income that investors receive from a REIT can fall into different categories, each with its own tax rules.
The two types of REITS
REITs come in two basic varieties, depending on how they make money:
- An equity REIT owns property, typically commercial real estate. It makes its money by collecting rent from tenants and from buying and selling properties.
- A mortgage REIT is essentially a lender: It finances mortgages, either by lending to borrowers itself or buying mortgages from banks that do. It makes money by collecting payments on those mortgages.
Some REITs are hybrids, involved in both kinds of activities. REITs generally don’t pay taxes themselves as long as they distribute at least 90% of their income to shareholders.
Type of payment determines tax treatment
Payments from REITs are referred to as "dividends," but they're a bit more complicated than dividends you receive from buying stock. Because REITs generate income in different ways, there are three types of dividends:
- Ordinary income: Money made from collecting rent or mortgage payments.
- Capital gains: Money made from selling property for more than the REIT paid for it.
- Return of capital: This is essentially the REIT giving you some of your own money back.
In general, "what happens in the REIT" dictates the tax treatment. Capital gains distributions, for example, are subject to capital gains taxes.
Holding REITs in retirement plans
If you hold an interest in a REIT as part of a tax-advantaged retirement savings plan, such as an IRA or 401(k), the different types of tax treatment don't really matter. That's because investment returns in such plans are not taxed when earned.
With traditional IRAs and 401k plans, you pay income tax when you withdraw money from your account. And if it's a Roth IRA or Roth 401(k), you don't pay tax on withdrawals at all. When you take money out of one of these retirement accounts, it doesn't matter whether it was a dividend, capital gain, or return of capital because all of the distributions are generally considered ordinary income.
Decoding your 1099-DIV
If you own shares in a REIT, you should receive a copy of IRS Form 1099-DIV each year. This tells you how much you received in dividends and what kind of dividends they were:
- Ordinary income dividends are reported in Box 1.
- Capital gains distributions are generally reported in Box 2a.
- Return-of-capital payments are reported in Box 3.
The instructions on the 1099-DIV tell you how to report each kind of payment on your tax return.
Ordinary income distributions
Dividends from REITs are almost always ordinary income. Box 1 of the 1099-DIV, where a REIT reports such dividends, has two parts:
- Box 1a shows your "ordinary dividends" or total dividends. These will normally be taxed at your regular income tax rate, the same as wages from a job, unless a portion or all of them are "qualified dividends".
- Box 1b shows "qualified dividends". These qualified dividends are included in the amount shown in Box 1a and are not in addition to the amount in Box 1a. This portion of qualified dividends gets taxed at lower capital gains rates. Generally, dividends from REITs are automatically exempt from being qualified dividends. Whether dividends are qualified depends on the nature of the investment that earned the money being passed along to shareholders.
Capital gains distributions
Normally, capital gains are taxed either as short-term gains or long-term gains, depending on how long you owned the investment. Tax rates on short-term gains, those from investments you owned for less than a year, are considerably higher than the long-term rates.
However, individual investors always report capital gains distributions from REITs as long-term gains, regardless of how long they've had money in the REIT.
Return of capital
Some dividends from a REIT are considered a return of your capital—meaning that you are getting some of your invested money back. These dividends aren't taxed at all, since it's just "your" money. However, these dividends reduce your cost basis in your REIT investment. The upshot of this is that when you sell your REIT shares, you will have a larger taxable capital gain. In other words, return of capital means no taxes now, but potentially a larger tax later.
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