Real estate investment trusts (REITs) are a popular investment vehicle for those interested in the real estate market without the direct ownership of property. However, understanding the complex tax structure is crucial for investors to make money with REITs. A financial advisor can help you figure out how this investment could fit into your portfolio. Here’s a general breakdown of the tax advantages and risks.
How REITs Work
Real estate investment trusts (REITs) are unique entities that own or finance income-producing real estate across various property sectors.
REITs are designed so that a variety of investors can fund these real estate purchases without having to put in the work of finding properties or managing them. The management team will take care of all the work in that regard while the investor just enjoys the benefits of successful investments.
When it comes to taxation, the tax burden frequently falls on the investors, who pay income tax on the dividends they receive. The tax implications of investing in REITs can vary given the type of REIT and the investor’s individual tax situation (we will explain taxes in a section below).
Understanding the Mechanics of REITs
REITs are corporations, trusts or associations that own and manage a real estate portfolio. As such, they provide avenues for individual investors to earn a share of the income produced through commercial real estate ownership or financing.
This investment essentially bridges the gap between real estate and equity investments. It allows investors to buy shares in real estate ventures like if they were buying ETFs. In this comparison, both financial investments:
- Can provide diversified exposure to a specific asset class
- Are typically traded on stock exchanges
- Can offer dividend income
Take note: While REITs can add diversity to your investment portfolio by spreading your risk across different asset classes, they can also be aggressive investments with his risk, comparable with stocks or cryptocurrency.
The Different Types of REITs
There are different types of REITs that you might be interested in investing in, depending on what you’re trying to achieve. Three common types include:
- Equity REITs own and manage real estate properties and collect rent
- Mortgage REITs lend money to real estate owners and operators either directly through mortgages/loans or indirectly through acquiring mortgage-backed securities.
- Hybrid REITs are a combination of equity and mortgage REITs.
All three types of REITs have different risk and return profiles. Therefore, you should consider your personal financial goals and risk tolerance before investing.
Understanding the Taxation of REITs
The taxation of REITs follows specific rules. Most notably, as long as a REIT distributes at least 90% of its taxable income as dividends to its shareholders, it is not required to pay any corporate income tax.
Additionally, investors might receive taxable dividends or other payouts when they cash in their ownership of the REIT, similar to how you would sell a stock.
The increase of your investment in a REIT is going to be treated pretty similarly to how an increase from a stock increase would be. This means that you’ll be paying capital gains tax on that increase and the amount you’ll pay depends on your other finances.
Take Advantage of This Tax Benefit Before It Expires
There is a current tax benefit for investing in REITs that is set to expire, at the end of the 2025 tax year. Individuals can currently deduct 20% of the pass-through income coming from REIT investments.
This can incentivize you to invest in a REIT right now as you may pay significantly less in taxes than you would have before this benefit was provided.
There is no guarantee that this tax benefit will be extended beyond 2025.
Bottom Line
REITs can provide a way for investors to participate in the real estate market and offer unique tax benefits. However, you should understand the tax implications and risks before investing to take full advantage for your portfolio.
Tips for Investing in Real Estate
- There are numerous ways to invest in real estate, including REITs. An experienced financial advisor can help you navigate the world of real estate investing and help you determine which, if any, are the best choices to help you reach your financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you canhave a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before investing in a REIT, make sure you have the right amount of money so that your investment becomes worthwhile.
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FAQs
Real estate investment trusts can categorize some of their dividend payments as return of capital, rather than taxable distributions. In this case, you pay no taxes on that portion of the dividend income. However the return of capital reduces your cost basis, setting you up for higher capital gains upon sale.
Are there tax benefits to REITs? ›
Individuals can currently deduct 20% of the pass-through income coming from REIT investments. This can incentivize you to invest in a REIT right now as you may pay significantly less in taxes than you would have before this benefit was provided. There is no guarantee that this tax benefit will be extended beyond 2025.
How do you avoid taxes on a REIT? ›
REIT Tax Overview
Dividends are tax deductible. At least 90% of net ordinary taxable income must be distributed and 100% is required to avoid REIT-level tax. REITs can't be closely held, as defined, and must have at least 100 shareholders.
Is it worth holding 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.
Why are REITs not suitable as tax advantaged investments? ›
Finally, REIT dividend taxation is truly "not that great." While dividends received from common stock investments, including mutual funds, qualify for the lower 15% or 20% tax rate, the tax law specifically denies this benefit to REIT dividend distributions. These are taxed at ordinary income tax rates of up to 39.6%.
How are REITs treated for tax purposes? ›
Unlike partnerships which are flow-through entities for tax purposes, REITs generally avoid entity-level tax by virtue of receiving a dividends paid deduction and by effectively being required to distribute all of their earnings and profits each year.
What are the pros and cons of REITs? ›
Real estate investment trusts reduce the barrier to entry for investors in the real estate market and provide liquidity, regular income and other perks. However, you'll be exposed to risks that aren't inherent in the stock market and dividends are subject to ordinary income tax.
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.
Are REITs taxed as ordinary income? ›
By default, all dividends distributed by a REIT are considered ordinary, or non-qualified, and are taxed as ordinary income. REIT dividends can be qualified if they meet certain IRS requirements.
Are REITs a bad investment? ›
In general, REITs are not considered especially risky, especially when they have diversified holdings and are held as part of a diversified portfolio. REITs are, however, sensitive to interest rates and may not be as tax-friendly as other investments.
REITs should generally be considered long-term investments
This is especially true if you're planning to invest in non-traded REITs since you won't be able to easily access your money until the REIT lists its shares on a public exchange or liquidates its assets. In many cases, this can take around 10 years to occur.
What are the best tax-advantaged investments? ›
Here are the most common accounts that can mitigate your tax burden: IRA, 401(k), or 403(b). Contributions to traditional IRAs and employer-sponsored 401(k)s and 403(b)s are made pre-tax, which lowers your taxable income for the year. Investments grow tax free and you pay income tax on withdrawals in retirement.
Where is the best place to hold a REIT? ›
Is a Roth or traditional IRA the best choice? To be clear, retirement accounts are ideal places to hold REIT investments, as the benefits of tax-deferred investing can magnify the already tax-advantaged nature of these companies.
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.
What are the downsides of REITs? ›
REITs don't have to pay a corporate tax, but the downside is that REIT dividends are typically taxed at a higher rate than other investments. Oftentimes, dividends are taxed at the same rate as long-term capital gains, which for many people, is generally lower than the rate at which their regular income is taxed.
Do REITs avoid double taxation? ›
Avoiding Double Taxation
That means REITs avoid the dreaded “double-taxation” of corporate tax and personal income tax. Instead, REITs are sheltered from corporate taxes so their investors are only taxed once. This is a major reason income investors value REITs over many other dividend-paying companies.
What is the 90 rule for REITs? ›
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
Are REITs taxed as qualified dividends? ›
REIT dividends are not qualified because the IRS considers them as pass-through income. These are profits that get distributed to investors without the entity paying taxes first. REIT dividends pass to investors as ordinary income. The IRS taxes the dividends according to the individual investor's income tax rate.
Does a REIT file a tax return? ›
Generally, a REIT must file its income tax return by the 15th day of the 4th month after the end of its tax year.
Are REITs good for a 401k? ›
REITs are a Potent Source for Retirement Income
As of October 2023, this still holds true at 4.59% and 1.61%. Beyond yields, however, a major benefit of REITs is their requirement to distribute most of their taxable income — at least 90% — annually to their shareholders as dividends.
