REITs offer many tax advantages that can translate into a solid, consistent stream of income for private REIT investors. This income stream can surpass what is available in the fixed income sector over time. Realizing the full advantage of this income stream and any tax benefits requires a knowledge of REITs and the guidance of qualified investment and tax advisors.
Publicly traded REITs are traded on a national stock exchange and registered with the SEC like shares of publicly traded common stock in a regular corporation. Public REITs can also be non-listed. These REITs share many characteristics of public REITs, but they are not traded on stock exchanges and may have redemption restrictions.
Private REITs are not listed on stock exchanges and are not subject to the same disclosure requirements as with public REITs.
In order to qualify as a REIT the entity must distribute at least 90% of its taxable income to shareholders each year.
The taxation of REIT income can be complicated. REITs distribute their income to shareholders in the form of dividend payments. Where it can become complicated is because the dividend income from REITs can be derived from one of three sources:
REIT dividends that arise from a distribution of the entity’s operating profit would normally be taxed at the REIT shareholder’s ordinary income tax rate. However, as a result of the Tax Cuts and Jobs Act of 2017, REIT dividends for noncorporate investors may qualify for a 20% Qualified Business Income deduction on ordinary dividend income for taxable years beginning before January 1, 2026, for purposes of determining their U.S. federal income tax, subject to certain holding period requirements and other limitations. This would mean that an investor in the current highest marginal tax bracket of 37% would only pay taxes at a 29.6% marginal rate.
If the income distribution is related to capital gains realized by the REIT, as long as those capital gains are long-term in nature, they will qualify for the preferential long-term capital gains tax rates. This is typically a maximum of 20%. In addition, both ordinary and capital gain dividends from a REIT may be subject to the 3.8% Net Investment Income Tax.
REIT capital gains arise when the managers of the REIT sell one or more of the underlying properties held by the REIT. The classification of each capital gain will depend upon the holding period for the property that was sold.
If a REIT distribution is deemed to be a return of capital, the distribution may not be subject to any sort of taxation. This type of situation generally arises when the REIT dividend includes a return of operating profit that was previously sheltered from income due to the depreciation of some of the underlying real estate holdings inside of the REIT.
It is important to understand that while dividends arising out of the return of capital will be nontaxable, this type of dividend reduces the investor’s tax basis in the REIT. This may lead to a higher level of capital gains when the REIT shares are sold.
For private REIT investors, these return of capital dividends can provide a solid tax planning opportunity, allowing these investors to manage their income stream and taxes in the near term.
In all cases, it is important for the investor to be sure they fully read and understand any communications received from the REIT regarding distributions and that they consult with their tax advisor regarding the tax implications.
The 20% Qualified Business Income Deduction mentioned above pertains only to ordinary REIT dividend income arising from taxable income of the REIT. This benefit does not apply to capital gain dividends that are already taxed at the preferential long-term capital gains tax rates.
This pass-through benefit that is available to noncorporate REIT shareholders has no cap on the deduction, no wage restriction, and itemized deductions are not required to receive this benefit. This makes the pass-through income deduction a very robust benefit for those who own shares of a REIT through the end of 2025.
REITs offer many tax planning opportunities including the ability for investors to diversify their investment income stream and to adjust it to fit with other income streams.
With this flexibility comes a need to ensure that investors work closely with their tax professional to ensure that they do not inadvertently violate any of the rules associated with REIT income and incur an unwanted tax hit.
First off, investors need to be sure an investment fund they are considering as a REIT actually qualifies as a REIT. REITs, like many companies, distribute earnings to investors in the form of dividends. Unlike many companies however, REIT incomes are not taxed at the corporate level. 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.
U.S. tax-exempt investors, such as churches, private foundations, pension funds, and charities wish to avoid unrelated business taxable income or UBTI. A REIT, if properly structured, can eliminate the issue of UBTI for tax-exempt investors on debt financed real estate investments.
Private REITs can be a solid investment for foreign investors, however there are a number of rules these investors need to be aware of in order to realize the best tax advantages from their REIT investments.
Overall private REITs can offer an opportunity for solid returns with a number of tax advantages. As with any investment, investors need to be sure to consult with a knowledgeable investment professional and tax advisor to make the most of any private REIT opportunity.
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