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 typically makes its money by collecting rent from tenants and from buying and selling properties.
- A mortgage REIT is essentially a lender: It typically 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 typically 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 typically 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 typically 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
- Qualified dividends in Box 1b
- 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 might have a larger taxable capital gain. In other words, return of capital means no tax now, but potentially more tax later.
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FAQs
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
How to avoid taxes on REITs? ›
Avoiding REIT dividend taxation
If you own REITs in an IRA, you won't have to worry about dividend taxes each year, nor will you have to pay taxes in the year in which you sell a REIT at a profit. In a traditional IRA, you won't owe any taxes until you withdraw money from the account.
What is the average return on a real estate investment trust? ›
The FTSE Nareit All REITs index, which tracks the performance of all publicly traded REITs in the U.S., had an average annual total return (dividends included) of 3.58% during the five-year period that ended in August 2023. For the 10-year period between 2013 and 2022, the index averaged 7.48% per year.
What is the problem with Real Estate Investment Trusts? ›
Non-traded REITs have little liquidity, meaning it's difficult for investors to sell them. Publicly traded REITs have the risk of losing value as interest rates rise, which typically sends investment capital into bonds.
What is the 2 year capital gains rule? ›
If you have lived in a home as your primary residence for two out of the five years preceding the home's sale, the IRS lets you exempt $250,000 in profit, or $500,000 if married and filing jointly, from capital gains taxes. The two years do not necessarily need to be consecutive.
How much of REIT income is taxed? ›
The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37% (returning to 39.6% in 2026), plus a separate 3.8% surtax on investment income. Taxpayers may also generally deduct 20% of the combined qualified business income amount which includes Qualified REIT Dividends through Dec.
Is it bad to hold REITs in a taxable account? ›
REITs and REIT Funds
Real estate investment trusts are a poor fit for taxable accounts for the reason that I just mentioned. Their income tends to be high and often composes a big share of the returns that investors earn from them, as REITs must pay out a minimum of 90% of their taxable income in dividends each year.
Are REITs worth the taxes? ›
The Bottom Line
REITs provide unique tax advantages that can translate into a steady stream of income for investors and higher yields than what they might earn in fixed-income markets.
Do real estate investment trusts do well in recession? ›
REITs historically perform well during and after recessions | Pensions & Investments.
What are the top 5 largest REITs? ›
Largest Real-Estate-Investment-Trusts by market cap
| # | Name | M. Cap |
|---|
| 1 | Prologis 1PLD | $96.34 B |
| 2 | American Tower 2AMT | $80.17 B |
| 3 | Equinix 3EQIX | $69.43 B |
| 4 | Welltower 4WELL | $55.75 B |
57 more rows“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio. Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any.
What is a disadvantage of a REIT? ›
Risks of investing in a REIT include market volatility, interest rate risk, dividend dependence, regulatory risks, management risks, limited control over the trust's properties and management, and lack of transparency.
Why are REITs doing so poorly? ›
Here's an explanation for how we make money . More than a year of interest rate hikes by the Federal Reserve pushed down returns on real estate investment trusts, or REITs. While higher rates negatively impacted nearly every sector of the economy in 2022 and most of 2023, real estate was hit especially hard.
Why not invest in REITs? ›
In most cases, REITs utilize a combination of debt and equity to purchase a property. As such, they are more sensitive than other asset classes to changes in interest rates., particularly those that use variable rate debt. When interest rates rise, REITs share prices can be prone to volatility.
Is there a capital gains loophole for real estate? ›
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
How do I reinvest without paying capital gains? ›
The like-kind (aka "1031") exchange is a popular way to bypass capital gains taxes on investment property sales. With this transaction, you sell an investment property and buy another one of similar value. By doing so, you can defer owing capital gains taxes on the first property.
How to avoid capital gains tax on investments? ›
How to Minimize or Avoid Capital Gains Tax
- Invest for the Long Term. You will pay the lowest capital gains tax rate if you find great companies and hold their stock long-term. ...
- Take Advantage of Tax-Deferred Retirement Plans. ...
- Use Capital Losses to Offset Gains. ...
- Watch Your Holding Periods. ...
- Pick Your Cost Basis.
When selling a primary residence property, capital gains from the sale can be deducted from the seller's owed taxes if the seller has lived in the property themselves for at least 2 of the previous 5 years leading up to the sale. That is the 2-out-of-5-years rule, in short.
