REIT shareholders’ income tax obligations might be complicated. Each distribution, or dividend payout, received by taxable account holders is made up of a mix of cash obtained by the REIT from a variety of sources and classifications, each with its own set of tax implications.
REIT dividends are frequently made up of the company’s operating earnings. As a proportional owner of the REIT firm, this profit is passed through to the shareholder as ordinary income and is taxed as nonqualified dividends at the investor’s marginal tax rate.
REIT dividends may, on occasion, comprise a portion of operational earnings that was previously tax-free due to depreciation of real estate assets. A nontaxable return of capital, often known as the ROC, is a portion of the dividend that is not taxed. While it lowers the dividend’s tax burden, it also lowers the investor’s per-share cost basis. The tax liability of current income generated by REIT dividends will not be affected by a fall in cost basis, but it will increase taxes due when the REIT shares are eventually sold. This provision may give income planning options for persons with higher taxable income in the near future, such as the potential to smooth income over numerous years.
Capital gains may make up a component of REIT dividends. This occurs when a firm makes a profit on one of its real estate properties. The length of time the REIT business had that particular asset before selling it determines whether the capital gains are considered short-term or long-term. The shareholder’s short-term capital gains liability is equal to their marginal tax rate if the asset was held for less than a year. Long-term capital gains rates apply if the REIT holds the property for more than a year; investors in the 10% or 15% tax brackets pay no long-term capital gains taxes, while those in all but the highest income group pay 15%. Long-term capital gains will be taxed at 20% for shareholders in the highest income tax level, which is now 37%.
Tax benefits of REITs
Through the end of 2025, current federal tax regulations provide for a 20% deduction on pass-through income. Individual REIT owners are allowed to deduct 20% of their taxable REIT dividend income (but not for dividends that qualify for the capital gains rates). There is no deduction limit, no minimum wage requirement, and itemized deductions are not required to enjoy this benefit. For a person in the highest tax band, this provision (qualified business income) effectively lowers the federal tax rate on ordinary REIT dividends from 37 percent to 29.6 percent.
A word on current tax reform
On April 28, the Biden administration proposed a $1.5 trillion increase in individual taxes to assist defray the costs of a huge family and economic infrastructure investment. Many of the tax plans are similar to hikes in tax rates for high-income earners that were proposed during the campaign.
Congress is currently debating infrastructure initiatives and negotiating potential legislation’s structure and text. This procedure will take up a significant portion of the closing months of 2021, and if passed, it will very certainly affect the tax rates of high-income individuals.
When looking into the world of REITs, it’s critical to grasp the potential rewards and requirements. The regulations of REIT taxes are unique, and depending on the situation, shareholders may incur different tax rates. As usual, you should seek advice from your own tax, legal, and investment professionals, as each person’s situation is unique.
Are there tax advantages to REITs?
Understanding the tax implications of investing in a Real Estate Investment Trust (REIT) is one of the most important factors when adding commercial real estate investments to a well-balanced portfolio approach “When analyzing various options, REITs may be beneficial. Currently, Jamestown is offering Jamestown Invest 1, LLC (the) (the) (the) (the) (the) (the) (the) (the) “Fund”), which is available to accredited and non-accredited investors in the United States. The Fund is established as a REIT with the goal of acquiring and managing a portfolio of real estate investments in urban infill regions that are expected to grow. By the end of this article, you should be able to spot potential REIT tax benefits and better interpret your 1099-DIV form, as well as understand a few IRS rules relevant to REIT investments.
What is a REIT?
The United States Congress first introduced REITs in 1960. Until then, institutional investors were the only ones who could invest in commercial real estate. Most people lacked the financial means or resources to make important and diverse investments in the space. The REIT structure was designed by Congress to address this imbalance. Individual investors were able to pool assets and make major investments in commercial real estate by investing in a REIT.
You may have also heard that REITs are a time-consuming vehicle to manage, and this is correct! It is not, however, without justification. Congress has set various restrictions on the structure and operation of REITs in order to ensure that they meet their legislative goals. The REIT must maintain certain levels of investment in real estate assets and earn particular levels of income from real estate and other passive vehicles in order to be considered a passive real estate investor. There are special shareholder criteria and constraints on the concentration of ownership of REIT shares to ensure that money are pooled by individual investors. REITs that meet these criteria receive preferential tax treatment (discussed in more detail below).
How Are Realized Returns Determined?
Before going into some of the tax advantages of investing in a REIT fund, it’s crucial to understand how commercial real estate trusts create profits for investors. Operating distributions and capital gain distributions are the two components of real estate realized returns.
- Investors receive operating distributions (usually monthly or quarterly) from the cash flow generated by the fund’s underlying real estate investments. This is usually achieved by net rental income or portfolio income from the REIT, such as interest and dividends.
- The capital gain from the sale of real estate within the REIT is the second component of realized returns potential.
How Are Realized Returns Categorized?
A REIT must transfer the bulk of its taxable income to its shareholders in order to maintain its beneficial tax status. REIT distributions are classified into one of the following types. There is a different tax treatment for each category.
- Capital Gains — depending on whether the investment or its underlying property is kept for less than or more than 12 months, capital gains are taxed at a short-term or long-term capital gain rate.
If you recall from our post on How to Invest in Real Estate with a Self-Directed IRA, if you own a REIT in a tax-deferred account like a regular IRA, you only pay taxes on the money when you remove it.
What Are the Potential Tax Benefits of Investing in a REIT?
REITs are eligible for special tax treatment if they meet the IRS’s standards. Eligible REIT structures, unlike other U.S. corporations, are not subject to double taxation. Dividends provided to shareholders help REITs avoid paying corporate income tax. Shareholders may then benefit from preferential US tax rates on REIT dividend distributions.
The Tax Cuts and Jobs Act (TCJA), which was signed into law in 2017, made REIT investing even more tax-efficient. Many taxpayers are eligible for a tax deduction of up to 20% for Qualified Business Income under the TCJA, subject to specified income criteria. Ordinary REIT dividends, interestingly, qualify as Business Income for this reason, and REIT dividends aren’t subject to the income thresholds, thus REIT investors can take advantage of this provision regardless of their income!
The qualified business income deduction is equal to the lesser of (1) 20% of combined qualified business income or (2) 20% of taxable income minus the taxpayer’s net capital gain amount (if any).
The hypothetical after-tax return shown below is based on a $10,000 investment with a 7% yearly dividend yield. We’ll assume a single tax filer who has no capital gains and is in the highest federal marginal tax rate of 37 percent in 2020.
Will I Receive a Schedule K-1 or Form 1099-DIV?
Investors frequently inquire about whether they will receive a 1099 or a K-1 at the start of the year. While a Sponsor’s Investor Relations or Tax Team can provide this information, there are some general standards to be aware of before investing.
A REIT, brokerage, bank, mutual fund, or real estate fund issues Form 1099-DIV to the Internal Revenue Service. Persons who have received dividends or other distributions of $10 or more in money or other property will get Form 1099-DIV. Dividend income is taxed in the state(s) where the person resides, regardless of the location of the property.
Schedule K-1 is an annual tax form issued by the Internal Revenue Service for a partnership investment. Schedule K-1 is used to report each partner’s portion of the partnership’s profit, loss, deductions, and credits. Real estate partnership income may be taxed in the state(s) where the property is located. A Schedule K-1 is identical to a Form 1099 in terms of tax reporting.
Understanding your IRS Form 1099-DIV
If you invest directly in a REIT, you will receive a 1099-DIV from the REIT. You’ll find that numerous boxes on your Form 1099-DIV have already been filled in. Some of the reporting boxes and their ramifications were recently detailed in an article released by TurboTax, a market leader in tax software for preparing US tax returns.
- The percentage of box 1a that is considered qualified dividends is reported in box 1b.
- If you get a capital gain distribution from your investment, you must record it in box 2a.
- If any state or federal taxes were withheld from your dividends, report them in boxes 4 and 14 for federal withholding and state withholding, respectively.
REITs that comply with the law are exempt from paying corporate taxes. Ordinary and capital gain dividend income are taxed at the REIT shareholders’ respective tax rates. Ordinary dividends paid by REITs can be deducted up to 20% before income tax is calculated.
Built-in diversification without the hassle of several state income tax forms is an advantage of investing in a fund with exposure to multiple properties. In comparison to investing in numerous individual properties via partnerships, investors will only pay state taxes on their dividends and capital gains in their individual state(s) of residence.
While many people are aware with publicly traded REITs that offer the tax benefits we’ve discussed, combining some of these benefits with non-correlative private real estate may be a viable option for investors looking for a more diversified portfolio. Alternative investments have been a part of many high-net-worth individuals’ and institutions’ portfolios for decades, but they are still not a portfolio staple for many people.
Are REITs going to recover?
According to NAREIT, the REIT industry generated roughly $52.4 billion in funds from operations (FFO) in 2020. That’s a drop of 18.5 percent from the previous year’s total. FFO, on the other hand, has consistently recovered since bottoming out in the second quarter. In the third quarter, it increased by 10.3% sequentially, and in the fourth, it increased by another 11.3 percent. FFO was now 16 percent lower than it was before the outbreak.
Lodging and resort REITs were the primary cause of the drop. The company’s fourth-quarter FFO was -$500 million, a far cry from the $1.1 billion it generated in the pre-pandemic fourth quarter of 2019. Hotels have been harmed by low occupancy rates, with the majority of them losing money last year. On a more optimistic note, hospitality REITs have witnessed a significant turnaround in recent quarters, after FFO fell to -$1.2 billion in the second quarter as the sector was hit by government-mandated shutdowns and travel restrictions.
Last year, retail REITs were another bad spot. FFO fell from almost $3.3 billion at the end of 2019 to roughly $2.3 billion in the second quarter of 2020, before rebounding to nearly $2.6 billion by the end of the year. Shutdowns imposed by the government also had an impact on the retail industry, making it more difficult for non-essential physical merchants to make enough money to pay their rent.
Since the pandemic began, FFO has been under pressure for office REITs, apartment-focused residential REITs, and healthcare REITs due to an increase in remote work and the devastation the senior housing industry has suffered. FFO has rebounded from its lows in all three sectors, which is a healthy sign.
Why REITs are a bad idea?
Because no investment is flawless, you should be aware of the possible negatives of REITs before incorporating them into your portfolio.
- Dividend taxation: REITs pay out higher-than-average dividends and aren’t subject to corporate taxation. The disadvantage is that REIT payouts don’t always qualify as “qualified dividends,” which are taxed at a lower rate than ordinary income.
- Interest rate sensitivity: Because rising interest rates are detrimental for REIT stock values, REITs can be extremely sensitive to interest rate movements. When the rates on risk-free investments like Treasury securities rise, the returns on other income-based investments rise as well. The yield on the 10-year Treasury is an excellent REIT indication.
- Real estate investment trusts (REITs) can help diversify your portfolio, but most REITs aren’t highly diversified. They tend to concentrate on a single property type, each with its own set of dangers. Hotel REITs, for example, are extremely vulnerable to economic downturns and other factors. If you decide to invest in REITs, it’s a good idea to pick a few with varying degrees of economic sensitivity.
- Fees and markups: While REITs provide liquidity, trading in and out of them comes at a significant price. The majority of a REIT’s fees are paid up front. They can account for 20% to 30% of the REIT’s total worth. This consumes a significant portion of your prospective profit.
How are REITs taxed in 2021?
Dividend payments are assigned to ordinary income, capital gains, and return of capital for tax reasons for REITs, each of which may be taxed at a different rate. Early in the year, all public firms, including REITs, must furnish shareholders with information indicating how the prior year’s dividends should be allocated for tax purposes. The Industry Data section contains a historical record of the allocation of REIT distributions between regular income, return of capital, and capital gains.
The majority of REIT dividends are taxed as ordinary income up to a maximum rate of 37% (returning to 39.6% in 2026), plus a 3.8 percent surtax on investment income. Through December 31, 2025, taxpayers can deduct 20% of their combined qualifying business income, which includes Qualified REIT Dividends. When the 20% deduction is taken into account, the highest effective tax rate on Qualified REIT Dividends is normally 29.6%.
REIT dividends, on the other hand, will be taxed at a lower rate in the following situations:
- When a REIT makes a capital gains distribution (tax rate of up to 20% plus a 3.8 percent surtax) or a return of capital dividend (tax rate of up to 20% plus a 3.8 percent surtax);
- When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20% maximum tax rate plus 3.8 percent surtax); and when a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20% maximum tax rate plus 3.8 percent surtax); and when a REIT distributes dividends received from
- When allowed, a REIT pays corporation taxes and keeps the profits (20 percent maximum tax rate, plus the 3.8 percent surtax).
Furthermore, the maximum capital gains rate of 20% (plus the 3.8 percent surtax) applies to the sale of REIT stock in general.
The withholding tax rate on REIT ordinary dividends paid to non-US investors is depicted in this graph.
Is 2021 a good time to buy REITs?
So far in 2021, real estate investment trusts (REITs) have performed admirably. The real estate sector’s almost 30% total return (price plus dividends) until the end of August handily outperformed the S&P 500 Index’s 21%+ return.
Even better, several variables indicate that REITs will continue to outperform other assets in the remaining months of 2021.
The first is a lack of high-yielding crops. Both the 10-year Treasury note and the S&P 500 are currently yielding a pitiful 1.3 percent. REITs, on the other hand, pay out more than double that, with an average yield of 2.7 percent, making real estate equities one of the best-paying sectors in the market.
Will REITs Recover in 2021?
In 2021, commercial real estate and REITs are expected to begin to recover, with the speed of recovery being determined by the availability and efficacy of a vaccine.
What is the maximum loss when investing in REITs?
A Real Estate Investment Trust (REIT) is a firm that produces and owns real estate to generate income. Some REITs are traded on the exchange, while others are not. Investors that invest in REITs are indirectly investing in the company’s real estate. Investing in REITs typically grants the investor voting rights, similar to ordinary shares of a firm.
REITs, unlike other real estate firms, do not construct real estate with the intention of reselling it. REITs hold or lease real estate and, as a result, distribute rental income to investors. Dividend-based income is what it’s termed. Office buildings, hotels, shopping centers, and houses, as well as data centers and cell towers, are examples of these properties. In typical market conditions, the income stream from a REIT investment can also be regarded somewhat stable because rents are usually stable.
Requirements for REITs
A corporation must meet specific criteria in order to be classified as a REIT. These requirements specify, for example, how a REIT should be run, what percentage of its assets should be real estate, and how much of its taxable revenue should be given to investors in the form of dividends. These percentages vary according on the REIT’s country of origin.
Typical examples of some of these provisions are:
- The majority of REITs’ taxable income must be distributed to shareholders. Typically, roughly 90% of the total must be distributed.
- Real estate must account for at least a specified percentage of the assets. This is usually around 75% of the time.
- Rent or sale of real estate, as well as interest on mortgages, must account for at least a portion of its gross income. This is usually around 75% of the time.
- A minimal number of people must own the beneficial ownership. A REIT may be required to have at least 100 shareholders if this is the case. This must be the case for at least 335 days in a taxable year, for example.
Different types of REITs
REITs come in a variety of shapes and sizes. These distinctions can be found in the manner in which investors can invest in them or in the type of product that a REIT specializes in.
A REIT does not have to be publicly traded, as previously stated. There are three different types of classifications:
- REITs that are publicly traded can be bought and sold on major stock markets such as the New York Stock Exchange and the London Stock Exchange. Because many REITs are traded on traditional stock markets, they have a higher level of liquidity than investing directly in real estate. This means that investors will be able to acquire and sell REIT shares more readily on the exchange.
- Non-exchange traded REITs are available to investors but do not trade on major exchanges.
- Private REITs: These REITs are not traded on a stock exchange and are not open to all investors. These private REITs can only be invested in by specified people who are usually nominated by the REIT’s Board of Directors.
REITs can hold a variety of assets, including real estate, mortgages, and other financial instruments. The following are some instances of specialized REITs:
Mortgage REITs, as you might expect, invest in mortgages. mREITs are another name for them. They may employ mortgages or loans directly or indirectly through mortgage-backed securities (MBSs).
Residential REITs are typically focused on residential real estate. Apartment complexes or single-family rental properties are examples of this. This can be narrowed even further; for example, some REITs specialize primarily in student housing or specific neighborhoods.
REITs can be diversified, unlike the very particular REITs discussed in the previous types. A REIT must own a mix of two or more types of properties to fall into this category. This could be a mix of shopping centers and office buildings, for example.
REIT dividends are subject to a different withholding tax than ordinary share distributions, and are frequently taxed more harshly. Before investing in a REIT, you should review the REIT’s investor relations page or speak with a local tax professional. The applicable tax will be determined by the type of distribution and the investor’s tax residency.
What are the risks and rewards of investing in REITs?
Investing in real estate investment trusts (REITs) can be profitable, but it is not without risk. DEGIRO is up forward and honest about the dangers that come with investing. The investor relations website of a REIT normally contains information on the REIT’s investment portfolio. Before investing in a REIT, it is a good idea to read the investor relations page. The maximum loss when investing in a REIT is equal to the total amount invested.
Regular income distributions and a potential price increase are two ways an investor might profit from a REIT investment. Dividends, rather than price appreciation, account for the majority of REIT returns. Capital appreciation is generally low because most income is transferred to shareholders. This, however, is not assured.
This material is not intended to be used as investment advice, and it does not make any recommendations. Investing entails taking risks. Your deposit may be lost (in whole or in part). We recommend that you only invest in financial products that are appropriate for your level of knowledge and experience.
Are REITs safe during a recession?
It’s crucial to remember that nothing can fully protect you against a recession. Any venture has weaknesses and hazards, and each economic downturn presents new obstacles.
While no recession is the same as the last, there are some real estate sectors that are more robust during a downturn. Real estate investments that meet people’s basic requirements, such as housing and agriculture, or that provide important services for economic activity, such as data processing, wireless communications, industrial processing and storage, or medical facilities, are more likely to weather the storm.
Investors can own and manage properties in any of the asset classes, but many prefer to invest in real estate investment trusts (REITs) (REIT). REITs can be a more affordable and accessible method for investors to enter into real estate while also obtaining access to institutional-quality investments in a diversified portfolio.
We live in a data-driven technology era. Almost everything we do now requires data storage or processing, and the demand for data centers will only grow in the next decades as more technological or data-driven gadgets are released. During recessions, more people stay at home to watch TV, use their computers or smartphones, or, in the case of the recent coronavirus outbreak, work from home, increasing the need on data centers. According to the National Association of Real Estate Investment Trusts, there are currently five data center REITs to select from, with all five up 33.73 percent year to date (NAREIT).
Self-storage is widely regarded as a recession-proof asset type. As budgets tighten, some families downsize, relocating to other places to better their quality of life or pursue a new work opportunity, or downsizing by moving in with each other to save money. This indicates that there is a higher need for storage.
The COVID-19 pandemic, on the other hand, has had an unforeseen influence on the storage industry. While occupancy has remained high, eviction moratoriums and increasing cleaning and safety costs have resulted in lower revenues. According to NAREIT, self-storage REITs are down 3.51 percent year to date. However, this industry is expected to recover swiftly, particularly for companies like Public Storage (NYSE: PSA), the largest publicly traded self-storage REIT, which has a strong credit rating and a diverse portfolio.
Warehouse and distribution
E-commerce has altered the way our economy works. Demand for quality warehousing and distribution centers has soared as more consumers purchase from home than ever before. Oversupply of industrial space, particularly warehouse and distribution space, is a risk, given that this sector has been steadily growing for the past decade; however, as a result of COVID-19, it has already proven to be the most resilient asset class of all commercial real estate, making it an excellent choice for a recession-resistant investment. Prologis (NYSE: PLD), one of the major warehousing and logistics REITS, and Americold Realty Trust (NYSE: COLD), a REIT that specializes in cold storage facilities, have both proven to be quite durable in the present economic situation, with plenty of space for expansion.
People will always require housing. Residential housing, which can range from single-family homes to high-rise flats or retirement communities, fulfills a basic need that is necessary even in difficult economic times. During economic downturns, rents may stagnate and evictions or foreclosures may increase, but residential rentals are a relatively reliable and constant source of income. Despite the COVID-19 challenges, American Homes 4 Rent (NYSE: AMH), which specializes in single-family rental housing, and Equity Residential (NYSE: EQR), which specializes in urban high-rises in high-density areas, are two of the largest players in residential housing, both of which have maintained high occupancy and collection rates.
Aside from housing, agriculture and food production are two additional critical services on which our country and the rest of the world rely. Our existing food system is primarily reliant on industrial agriculture, but more and more autonomous and regenerative agricultural projects are springing up, allowing for more crop diversification, increased productivity, and reduced economic and environmental risk.
Wireless communication has grown into a giant sector, with American Tower (NYSE: AMT) and Crown Castle International (NYSE: CCI) being two of the world’s largest REITs. Cell tower REITs that provide telecommunication services are an important part of our world today, and while growth prospects can be difficult to come by, very good track records and rising demand make this a terrific real estate investment that will weather any economic downturn.
Medical facilities, senior housing, hospitals, urgent care clinics, and surgery centers all provide a vital service that will always be in demand, even during economic downturns.
Before you abandon ship when you see this category, let me state unequivocally that retail is not dead, at least not in all forms. Grocery stores and other retail outlets that provide critical services and products will continue to be in demand, as they did during the last pandemic. The issue here is for retail REITs to invest in the vital service sector with such focus that other sectors such as tourism, restaurants, or general shopping and goods do not put the company or investment at risk.
Where do REITs go on tax return?
Dividend payments are a frequent technique to make these transfers. Dividends can be fully PID, entirely non-PID, or a combination of the two; on a dividend-by-dividend basis, the Board will determine the most appropriate make-up. Furthermore, the Scrip Dividend Alternative’s PID/non-PID make-up may differ from that of the underlying cash dividend.
PID & non-PID dividend payments
Shareholders should be aware that PID and non-PID dividends have different tax treatment. In the hands of tax-paying shareholders, PIDs are taxable as property letting income, but they are taxed independently from any other property letting revenue they may get.
Forms for requesting withholding tax exemption on PID dividend distributions are available:
- The PID from a UK REIT is included on the tax return as Other Income for UK residents who receive tax returns.
- Dividends received from non-REIT UK companies will be regarded in the same way as dividends received from REIT UK companies. From April 6, 2016, the non-PID element of dividends received by UK resident shareholders liable to UK income tax will be entitled to the tax-free Dividend Allowance (£5,000 for 2016/17) if they are subject to UK income tax. It should be noted that the PID component of dividends is not covered by this allowance.
- Any normal dividend paid by the UK REIT is included on the tax return as a dividend from a UK firm for UK residents who receive tax returns. Your dividend voucher will list your firm shares, the dividend rate, the tax credit (for 2016 and preceding years), and the dividend payable. Add the tax credit to the total dividend payments in box 4 on page 3 (box references are for the 2018 return).
Sale of shares by UK and non-UK resident shareholders
Gains realized by non-UK residents must be disclosed to HM Revenue & Customs within 30 days of the transaction.
Gains realized by UK citizens should be recorded as usual on the tax return.