Understanding the Tax Implications of Investing in Real Estate Investment Trusts (REITs)

  • January 10, 2023
  • OHI

Real estate investment trusts (REITs) serve as a preferred option for those who want to invest in real estate but don’t want the hassle of buying or managing a property. 

Due to their high yields, real estate investment trusts are popular among investors. However, REIT dividends, despite their attractiveness due to their consistent stream of payments, are subject to peculiar tax treatment.  In this article, we’ll discuss the prominent Tax Implications of REITs and several other associated aspects.

What are the Tax Implications of REITs?

The tax implications of REITs can be on the trust and unitholder level. If an organization wants to be considered a REIT, it must have significant real estate-related assets and revenues.

In addition, 90% of its total taxable income must be distributed to stockholders. In contrast, unitholders get taxed on payments received through REITs in the form of dividends.

How are REITs Taxed for Investors?

The dividends you receive as REIT shareholders are generally subject to taxation at our standard rate of personal income taxation. Dividend income from REITs can be classified as follows:

Ordinary Income Distributions

If the dividends are considered ordinary income, your tax rate will be determined by the total income and tax bracket.

Capital Gains Earnings

You would have to pay capital gains tax on any dividends distributed to you by the REIT if it realized a profit from the sale of a property.

Return of Capital

It implies that the REIT is essentially returning a portion of your investment. While you won’t have to pay taxes on these dividends right away, they will reduce your cost basis, which could result in a higher capital gains tax if and when you decide to sell your REIT shares in the future.

How Can You Avoid Taxation on REITs?

Holding REITs in an individual retirement account (IRA) ensures an investor won’t be liable to pay taxes on dividends each year or on gains made when selling the shares.

You won’t be taxed on the earnings in the traditional IRA until you take money out of it. Further, withdrawals from a Roth IRA are tax-free as long as they meet the IRS’s conditions.

Moreover, investing in severaltypes of REITs through a taxable brokerage account isn’t always a poor decision. However, due to the complexities of REIT taxation, they are best suited for IRAs.

By doing so, both corporate and personal income taxes can be deferred or avoided entirely, which is great news for real estate investment trust investors.

How Do REITs Avoid Double Taxation?

REITs, much like other types of corporations, give a portion of their profits to their shareholders in the form of dividends.

However, in contrast to the majority of corporations, REIT incomes are exempt from taxation at the corporate level. It is among the most significant REIT tax advantages for corporations.

Because of this, REITs are exempt from the feared “double taxation” imposed by the combination of the tax on corporations and the tax on individual income. Instead, real estate investment trusts are insulated from corporate taxes, implying that their shareholders are only subject to a single layer of taxation.

For this vital reason, income investors tend to place a higher value on REITs when compared to many other dividend-paying businesses.

How to Reduce the Tax Liability by Using a 1031 Exchange to Invest in REITs?

A 1031 exchange cannot be used to fund the purchase of publicly traded REITs with the proceeds from the sale of a rental or commercial property. Taxes on capital gains and depreciation recapture are something you must account for. 

Although it is not feasible to directly transform 1031 into a REIT, you could perform a 1031 exchange to acquire an interest in the real estate held by a REIT. Yet another valuable concept to enjoy significant tax benefits of REITsis an umbrella partnership REIT (UPREIT).

Real estate investors looking to defer and minimize capital gains tax by exchanging an investment property for REIT shares can benefit from a novel option provided by UPREITs.

In the case of an UPREIT, the property is owned by an operational partnership. The REIT serves as the exclusive general partner and holds a sizeable number of OP units.

You can use an UPREIT to defer your tax on capital gains by contributing property to the OP in compensation for OP units. Rather than owning shares in the REIT, you will have stakes in the operating partnership.

How to Report and Track REIT Income and Expenses on the Tax Return?

There are two types of IRS forms issued for REIT income and expense reporting:

Form 1099-DIV

It is a form from the IRS that a REIT, broker-dealer, financial institution, mutual fund, or real estate fund gives out.

Form 1099-DIV is given to people who received dividends or other distributions worth $10 or more in cash or property. Dividend income is taxable in the state or states where the owner lives, no matter where the property is located.

Schedule K-1

This is another IRS form issued once a year to those who have capital contributions to a partnership. Each partner’s proportion of the partnership’s income, deductions, and credits must be reported on Schedule K-1.

Taxes on revenue from a partnership’s real estate holdings may be levied by the state or states where those holdings are located.

Those who invest directly in REITs will receive a 1099-DIV from the REITs. Some of the reporting boxes under this form include:

  • Box 1a (reports total ordinary dividends amount)
  • Box 1b (shows qualified dividends from box 1a)
  • Box 2a (reports capital gain distributions from investments)
  • Boxes 4 and 14 (report federal and state taxes withheld from payouts)

Conclusion

It’s critical to understand the dividend tax treatment of REITs before making any investments in these entities.

During the course of a year, you may receive dividend payments from a REIT, on which you will owe income tax. The excellent thing is that you will be issued a detailed accounting of your dividend and capital gains income to help you file your taxes accurately and efficiently.

Though, you should consult with real estate accountants and tax advisors because every investment has unique tax concerns.

About Us

OHI is a sixteen-year-old real estate services company working with 75+ commercial and residential real estate developers, funds and property management companies across USA. Our deep expertise in real estate accounting, financial analysis, lease administration and asset management has helped clients cut associated costs by 40-50%. We currently provide these services to a portfolio of 100,000 units across clients.


OHI provides REIT accounting and related services through our team of experienced real estate portfolio accountants. OHI team members are well versed with US GAAP norms including real estate accounting rules including Real Estate Information Standards (REIS) as per NCREIF. OHI has experience with real estate companies that own and manage office, multifamily, retail, industrial and other real estate investments, including proficiency in both traditional and mortgage REITs. – VIEW MORE

Certifications And Membership