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With REITs, the company owns, operates, finances, and collects income from real estate property. How do you account for the taxes on REIT? You gain from receiving dividend income or capital gains if the company sells the property.
Corporate and dividend stock taxes on your REITs are irrelevant to standard stocks and other investments. The company doesn’t pay any corporate tax; it falls under the pass-through business category.
However, according to the IRS, it has to distribute at least 90% of its income to the investors in dividends.
Understanding REIT Taxation
REITs allow companies to pool funds from various individual investors and acquire property investments.
Individual REIT taxation covers dividend and capital gains taxes, while the corporate tax has special tax status.
The REIT tax form sheet contains dividend taxes, capital gains or losses, and return of capital taxes. Get to know more about these individual REIT taxations.
The bulk of dividends paid falls under ordinary income. People view this income as a pass-through income generated from the trust’s activities on the property, like leasing or rental income.
It takes up the bulk of the cost of the dividend (over half of the dividend per share). Taxpayer s should pay dividend tax at the marginal tax rate for the amount allocated as ordinary income.
If your income tax bracket is at 22%, the dividend tax rate on the categorized ordinary income should be the same. At this rate, you’d get $50,000 from an ordinary income of $11,000.
REIT dividends also offer up to a 20% deduction on your qualified business income, but only on the portion of qualified dividends considered ordinary income.
The interest on these dividends or shares doesn’t count when calculating these tax cuts. For example, if you have 200 shares in a REIT company, you should get $2.5 ordinary income as part of the dividend.
You’ll only have to pay taxes on $800 of the ordinary income. That is 20% less than the ordinary income you expect to receive.
Long-term capital gains and losses
You receive capital gains or losses when you sell your shares or when the company sells some of the properties it has held for more than a year.
The company usually passes on the losses to the investor and will affect your overall dividend payout as it relies on the income generated.
The remaining portion after deducting the ordinary income constitutes the return of capital. You’ll use a long-term capital gains tax rate when taxing your capital gains from REIT investments.
All REIT tax cards’ capital gains fall in this tax bracket regardless of the time you’ve had your REITs. Your qualified taxable income affects the tax on your capital gains.
Your income tax determines the charges on your capital gains; the capital gains tax rate ranges from 0% to 20%.
The income tax card of the year you file your capital gains should guide you on filling your REIT tax form.
Return of capital
The return of capital occurs when the REIT company has fewer expenses or cash distributions than its earnings. You get back some of your investment capital, thus reducing your initial cost (sometimes to zero).
However, it also increases your capital gains liability, meaning you’ll have to pay more capital gains taxes. These dividends don’t accrue taxes when returned. You don’t tax your return on capital on the year of return, and you’ll have to pay taxes when you sell your shares.
Alternatively, you’ll have a significant increase in capital gain tax.
Taxes on REIT Dividends
Taxes on REITs dividends depend on the dividend distribution and your qualified income. You may have the same number of shares as someone else, but if your income is in a different tax bracket, you’ll get different tax values when filing.
You should understand the allocation of your dividends across capital gains/losses, ordinary income, and return on capital. The priority is to distribute the ordinary income dividends that take a higher percentage of the cost per share.
For example, if the dividend per share is $2, the ordinary income allocated per share is $1.4, and the remainder becomes the return on capital. Therefore, your dividend tax will only be per the $1.4 ordinary income.
Your cost basis will reduce by $0.6. When you sell your shares, you’ll get taxed on your capital gains. If your cost basis reduces as a result of getting the returns of capital, your capital gain tax responsibility could increase.
Example of REIT Taxation
Consider this REIT taxation example. If you buy 100 REIT shares for company ABC at $10 each, your total investment for the REIT company becomes $1,000.
Suppose your income is within the $55,000 tax bracket that attracts a tax rate of 22%. Also, your dividend payout per share is $1.2, where $1 is the allocated ordinary income.
Your total payout should accumulate to $120, but only $100 is taxable at 22%, so you’ll get $88. Since you qualify for a 20% reduction of your qualified business income from ordinary income, the ordinary taxable income reduces to $80.
With this tax benefit, you enjoy a higher dividend payout than expected. The $20 return on capital reduces your cost basis by $0.2. It causes your per-share value to be $0.8.
Any sale on your shares attracts the capital gain tax, but it won’t attract any tax penalties during payout.
REIT Tax Advantages & Benefits
Every investor expects to get handsome returns when investing in different ventures. REITs are no exception; the tax and financial benefits you get from REITs should align with your financial plan.
Whether you are in it short or long term, expect these REIT tax benefits:
- A 20% tax deduction on ordinary income allocated from the dividend payout.
- You don’t need special wage restrictions or deductibles to enjoy your tax deduction.
- The deduction lowers your federal tax rate up to 29.6% on the highest tax bracket.
- The deferred tax on capital gains until their sale boosts your current financial gains.
Tax deduction on pass-through income: The state provides for a 20% deduction on every pass-through income, including the REITs’ dividends.
The primary income from REITs is from rental income or their property in business. As a result, your qualified taxable income reduces, helping you gain money from the venture.
Depreciation: Investment companies usually account for asset depreciation in income and profit calculations. They spread the depreciation expense across the expected lifespan of the equipment.
For example, suppose you have a machine costing $5,000 and a predicted ten-year lifespan. The company can deduct $500 yearly from its income to cater to its depreciation.
However, REITs have a unique approach. Since property value often increases rather than depreciates, they can record an increase in their property value or assets, which could be your return on capital.
This reduction in taxable dividends helps you get more dividends per share than when you include the depreciation factor.
In the example above, if the company doesn’t have to include the $500 as an expense, the distributed income will increase.
If they allocate this difference as a Regulated Investment Company (RIC), your taxable dividend reduces, thus increasing your investment returns for the period.
The 90% Rule: REIT companies should distribute at least 90% of their income to investors. For example, if they generate a $4 payment per share, the company should allocate at least $3.6 per share to qualify for the firm’s tax benefits.
The 90% rule focuses on the firm’s income earnings, making it less relevant where the company generates its income.
Avoiding Double Taxation: REITs avoid double taxation; the firm doesn’t pay any income or corporate tax if it meets the set requirements.
Individuals don’t have to pay taxes on their return on capital, only on their capital gains. It makes it easier for people to track their tax expenses from investments.
Investing in REITs can help you achieve your long- and short-term financial plans. In addition, understanding REIT taxation enables you to understand the economic impact of investments.
Take note of the type of REITs you’re going for and how each category affects your final financial return. Then, learn and utilize this REIT tax information to align your financial plan for better returns.
REIT Taxes FAQs
Continue reading for FAQs on REIT taxes.
What are qualified REIT dividends?
Qualified REIT dividends are the amount of your dividend per share that qualifies for taxation as ordinary income.
How do you avoid taxes on my REIT?
You can avoid taxes on your REIT by having a higher return on capital, but it will reduce your share cost basis.
Where to put REIT income on the tax return?
You’ll fill in form 1099-DIV (boxes 1 to 3) on your REIT returns.
What are the REIT distribution requirements?
A company should distribute at least 90% of its income earnings.
What is the tax rate for REIT dividends?
The REIT dividend taxes rate for ordinary income depends on your income tax bracket.
The capital gains tax rate is also dependent on how much you earn.