Essentially a real estate investment trust is a mutual fund for real estate. The trust invests in real-estate related investments, as the name implies. The trust’s investors buy shares and the REIT transfers income from its holdings back to them. Real estate can generate different types of cash flow so income received from a REIT may fall under different tax categories.
REITs can be classified into two types depending on their ability to make money.
- An Equity REIT owns commercial real estate, usually property. It earns its money from renting properties to tenants, and also from the sale and purchase of properties.
- A REIT mortgage is an intermediary lender. It lends money to borrowers or buys mortgages from banks that offer it. It collects the mortgage payments.
Some REITs can be hybrids and engage in both types of activities. As long as the REITs distribute at least 90% to shareholders, they don’t have to pay taxes. REITs are extremely important to know when you are continuing education in real estate or when you are looking into becoming a real estate agent.
Tax Treatment is Determined By the Type of Payment
Although “dividends” are sometimes used to describe payments from REITs, they can be a lot more complex than the dividends you get from stocks. There are three types of dividends, depending on how REITs generate income.
- Ordinary income: Money earned from collecting rent payments or mortgage payments.
- Capital gains: The REIT pays more for the property than it is worth which is beneficial when buying your first home especially.
- Capital return: This is basically the REIT that gives you some of your money back.
The tax treatment is determined by what happens within the REIT. Capital gains distributions are, for instance, subject to capital gains tax.
Retirement Plans: Holding REITs
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. This is because the investment returns from such plans are not subject to tax when they are 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. It doesn’t matter if the money was a capital gain, dividend, or return on capital, as all distributions are considered normal income.
Your 1099-DIV Code Can Be Decoded
If you own shares in a REIT, you should receive a copy of a 1099-DIV every year. These will be subject to the regular income tax rate. This is the same as wages earned from a job unless they are “qualified dividends”.
- Ordinary income dividends are reported in Box 1.
- Capital gains distributions are usually reported in Box 2a.
- Return-of-capital payments are reported in Box 3.
Capital Gains Distributions
Capital gains are normally taxed as Short-term gains or Long-term gains the amount depends on how long the investment was owned. The tax rates for short-term gains (investments that you own for less than one year) are significantly higher than long-term rates.
Individual investors report capital gains distributions from REITs, regardless of how long the investor has been a member.
Capital Return
Dividends from REITs can be considered a return on your capital. This means that you get some of your money back. Since it is “your” money, these dividends won’t be taxed. However, these dividends reduce your cost basis in your REIT investment.
This means that your taxable capital gain will be greater when you sell REIT shares. This means that return of capital can be described as no tax now but possibly a higher tax in the future. If you don’t know where to start on getting into REITs, contact a good real estate broker for advice.