Understanding How Are REITs Taxed and Their Benefits

REITs are a popular investment option for many, offering a unique way to own a piece of real estate without directly managing properties.

One of the main benefits of REITs is that they are required to distribute at least 90% of their taxable income to shareholders, making them a relatively tax-efficient investment.

This means that REITs are a great option for investors looking to diversify their portfolio and reduce their tax liability.

However, REITs are also subject to certain taxes, including ordinary income tax and capital gains tax.

REITs are corporations for income tax purposes and must own predominantly rental real estate assets or debt secured by real estate.

They must meet a vast and nuanced array of organizational, operational, asset, and income tests. This includes having at least 100 shareholders and not being closely held, as defined.

REITs can deduct dividends they pay out to their shareholders, which is why they often pay out 100 percent of their taxable income. This special tax treatment allows them to attract tax-exempt investors and foreign investors with favorable tax treatment.

Here's a summary of the tax implications for REITs:

There are two main types of REITs: equity REITs, which own and collect rent from properties, and mortgage REITs, which typically finance mortgages and collect payments.

If you hold REITs in a tax-advantaged retirement savings plan, such as an IRA or 401k, the tax treatment of dividends typically doesn't matter.

REITs have three general types of "dividends" based on their income: ordinary income, capital gains, and return of capital. These different types of dividends have unique tax treatments and are reported on different boxes on the 1099-DIV form.

Here's a quick rundown of the tax implications of each type of REIT dividend:

This information can help you understand the tax implications of investing in REITs and make informed decisions about your investments.

A REIT can have properties in multiple states, but as long as you're a shareholder or partner, you only pay taxes on the dividends in your state of domicile.

This means you won't have to file tax returns in each state where the REIT operates, which can be a big administrative hassle.

The fund that owns the REIT also avoids state withholding tax on the dividends, which can improve cash flow and reduce upkeep.

If you live in a zero- or low-income tax state, the benefits of REITs compared to partnerships can be substantial, especially if you'd otherwise have to pay taxes in higher tax rate states.

Carry allocations above a REIT get favorable treatment, which is great news for real estate fund sponsors. This favorable treatment includes exemptions from the general three-year holding period rule for carry capital gains.

For IRC Section 1231 assets, the holding periods and character of gains within the REIT flow up to the shareholders for purposes of applying carry rules. This means that if the gain is sourced from direct real estate that qualifies as an IRC Section 1231 asset sale gain, it's excluded from the three-year holding-period rule.

The gain is taxed only in the state of domicile of the partner receiving the carry allocation. This can be beneficial for sponsors looking to minimize tax liabilities.

REIT capital gain dividends are subject to a 3.8% net investment income tax, which should be considered when determining where to locate carry allocations in the fund structure.

Here are the key outcomes of carry allocations of REIT long-term capital gain dividends:

If you own shares in a REIT, you'll receive a copy of IRS Form 1099-DIV each year, which breaks down your dividend payments into different types.

Ordinary income dividends are reported in Box 1 of the 1099-DIV, while qualified dividends are listed in Box 1b.

Capital gains distributions are generally reported in Box 2a, but the instructions on the form will tell you exactly how to report them on your tax return.

Return-of-capital payments are reported in Box 3 of the 1099-DIV, which can affect the taxes you owe on your REIT investments.

Here's a breakdown of the different types of payments you might see on your 1099-DIV:

The instructions on the 1099-DIV will guide you on how to report each type of payment on your tax return.

Ordinary income distributions from REITs are taxed at your regular income tax rate, just like wages from a job.

Dividends reported on Box 1a of the 1099-DIV are considered ordinary income, and they're not exempt from taxation. These dividends are normally taxed at your regular income tax rate.

Box 1a of the 1099-DIV shows two parts: ordinary dividends and qualified dividends. There is no additional amount for qualified dividends, as they're included in the ordinary dividends amount.

Qualified dividends, reported on Box 1b, are taxed at lower capital gains rates. However, dividends from REITs are generally exempt from being qualified dividends, unless the investment that earned the money being passed along to shareholders qualifies.

When you receive dividends from a REIT, they're considered ordinary income. This means they're taxed at your regular income tax rate, just like wages from a job.

Dividends from REITs are reported on the 1099-DIV, which has a box for ordinary income distributions. Box 1a shows the total amount of ordinary dividends, which will be taxed at your regular income tax rate.

Ordinary dividends are not the same as qualified dividends, which get taxed at lower capital gains rates. However, most dividends from REITs are automatically exempt from being qualified dividends.

It's worth noting that qualified dividends are included in the amount shown in Box 1a, but they're not in addition to it. This means you can't just add the qualified dividends on top of the ordinary dividends to get your total tax liability.

Some dividends from a REIT are considered a return of your capital, meaning you're getting some of your invested money back. These dividends aren't taxed at all, since it's just "your" money.

This is a nice perk, but it's essential to keep in mind that return of capital reduces your cost basis in your REIT investment.

When you sell your REIT shares, you might have a larger taxable capital gain due to this reduced cost basis.

Capital gains from REITs are always reported as long-term gains, regardless of how long you've owned the investment. This means you'll pay lower tax rates on your capital gains from REITs compared to short-term gains from other investments.

Individual investors can expect to pay lower tax rates on their capital gains from REITs, which is a nice benefit. However, it's worth noting that this doesn't affect the overall tax implications of your REIT investment.

Some dividends from REITs are considered a return of capital, which means you get some of your invested money back. This type of dividend isn't taxed, but it does reduce your cost basis in your REIT investment, potentially leading to a larger taxable capital gain when you sell your shares.

A Qualified Foreign Pension Fund (QFPF) can use a REIT to enjoy tax-free real estate appreciation and gain on exit. This is a great benefit for non-US investors, as it allows them to avoid paying taxes on indirect US real estate gains.

Capital gains distributions from REITs are always reported as long-term gains, regardless of how long you've had money in the REIT. This means you'll pay a lower tax rate on these gains compared to short-term gains.

One important thing to note is that REITs always report capital gains distributions as long-term gains, unlike other investments. This can help reduce your tax liability on these gains.

If you're investing in a REIT, it's essential to understand how capital gains distributions work, as they can impact your tax bill. By knowing how these distributions are taxed, you can make more informed investment decisions.

Here's a quick summary of how capital gains distributions are taxed:

Keep in mind that while long-term capital gains distributions from REITs are taxed at a lower rate, you might still face a larger tax bill if you have a return of capital.

QFPFs can use a REIT to enjoy tax-free real estate appreciation and gain on exit.

Ordinary REIT dividends paid to QFPFs are subject to US-source withholding, net of treaty benefits.

The special rules applying to QFPFs are intended to increase capital flows into the United States.

A QFPF can benefit from untaxed gains on REIT shares, including when held indirectly through a fund.

The following are untaxed for a QFPF:

A REIT can deduct the dividends it pays out to its shareholders, which is a special tax treatment that most REITs take advantage of by paying out 100 percent of their taxable income.

This means they owe no corporate tax, making them attractive to tax-exempt investors and foreign investors with favorable tax treatment.

REITs must distribute at least 90% of their net ordinary taxable income to avoid paying REIT-level tax, and 100% is required to avoid any tax at all.

Dividends are documented on a 1099 and consist of ordinary income and sales gains, representing a shareholder's proportional share of the REIT operation for the year.

By meeting the required distribution percentage, REITs can be highly efficient and useful vehicles for real estate assets and debt.

The Pass-Through Deduction, also known as 199A, is a game-changer for individual investors. This provision allows rental real estate and certain debt funds to produce a 20% partner-level deduction for their investors.

Rental real estate funds may have trouble meeting the wage and tangible property requirements, which can limit their eligibility for the deduction. Many debt funds, on the other hand, pay a fee to a sponsor or manager, which can make it difficult to allocate wages.

REITs, however, have it easier – they produce ordinary dividends that categorically qualify for the 20% deduction, subject to further shareholder or partner level limitations. This can be a simplification and tax benefit for investors.

Locating real estate rental and debt assets into or beneath a REIT can produce additional simplification and tax benefits for investors, especially for non-US operations.

REITs offer a unique tax benefit that allows them to deduct dividends paid to shareholders, which can be a major advantage for investors. This special tax treatment means that most REITs pay out 100 percent of their taxable income to shareholders.

As a result, REITs owe no corporate tax, giving them a significant cost advantage over other types of companies. This is one reason why REITs can attract tax-exempt investors and foreign investors with favorable tax treatment.

Their unique tax benefits also enable REITs to pass the tax savings on to their investors, making them an attractive option for those looking to minimize their tax liability.

There are several types of REITs, including Equity REITs, Mortgage REITs, and Hybrid REITs.

Equity REITs are the most common type, accounting for the majority of REITs.

Mortgage REITs invest in mortgages and other types of real estate debt.

Hybrid REITs combine elements of both equity and mortgage REITs.

REITs are categorized into three main types: equity REITs, mortgage REITs, and hybrid REITs. These categories determine how a REIT generates its income and invests in real estate.

Equity REITs own and operate income-producing real estate, which is the most common type of REIT. They're like landlords, but instead of renting out individual apartments, they own entire buildings or complexes.

Mortgage REITs provide money to real estate owners and operators through mortgages or other types of real estate loans, or by acquiring mortgage-backed securities. This allows them to earn interest on the loans they make.

Hybrid REITs use a combination of equity and mortgage REIT strategies, making them a bit of both worlds. They're a versatile option for investors who want to diversify their portfolio.

Domestically Controlled REITs can be a game-changer for non-US investors looking to monetize their investments efficiently.

In a fund setting, a domestically controlled REIT is more than 50% owned by US persons, which means it falls outside of the FIRPTA regime.

This allows non-US owners to sell REIT shares or partnership units holding REIT shares free of US tax, providing a tax-efficient path for investor monetization.

Non-US owners can sell REIT shares or partnership units above the REIT, or even get redeemed before a gain on sale dividend, which would otherwise attract FIRPTA withholding.

There's no comparable exception for interests in partnerships owning real estate directly, so domestically controlled REITs can be a more attractive option for non-US investors.

A REIT, or Real Estate Investment Trust, is a company that owns or finances real estate properties and provides a way for individuals to invest in real estate without directly owning physical properties.

To qualify as a REIT, a company must meet certain requirements, such as distributing at least 90% of its taxable income to shareholders each year, as seen in the "Qualifying as a REIT" section.

A REIT can be publicly traded on major stock exchanges, allowing individuals to buy and sell shares just like stocks, as explained in the "Types of REITs" section.

In order to qualify as a REIT, a company must also derive at least 75% of its gross income from real estate-related sources, such as rents and property sales, as mentioned in the "Qualifying as a REIT" section.

The REIT structure provides a way for individuals to invest in a diversified portfolio of properties, without having to manage the day-to-day operations of individual properties, as seen in the "Benefits of REITs" section.

This structure also allows REITs to raise capital from a large number of investors, making it easier to finance large-scale real estate projects, as explained in the "Types of REITs" section.

Non-US investors may face challenges with direct fund investments, including those with a REIT beneath the fund, due to potential withholding taxes.

Direct investments can be subject to significant withholding taxes, particularly where there is limited or no treaty relief.

A taxable C-corp blocker with mezzanine debt leverage from its investors or feeder fund can be an efficient solution for non-US investors.

The 30% interest expense limitation can be a drawback for some blockers, but it can be turned off for an electing real property trade or business (RPTOB) in some cases.

A levered captive REIT, using a REIT safe harbor, can elect RPTOB status to obtain unlimited interest expense deductions.

This structure can be particularly effective for non-US investors who can't tolerate direct fund investments.