REIT Tax Treatment

You already know REITs must distribute 90% of taxable income. Now let's dig deeper into how those distributions are taxed, because the exam tests several nuances here.

Entity-Level Taxation

• REITs that distribute 90% or more of taxable income are not taxed at the entity level
• This eliminates double taxation (the same benefit DPPs provide through pass-through structure)
• The trade-off: REIT dividends are taxed at higher rates for shareholders

Shareholder Tax Treatment

Key points:

• Most REIT distributions are taxed as ordinary income (not the lower qualified dividend rate)
• Ordinary income rates apply because the REIT itself does not pay corporate tax; the income has never been taxed before reaching the shareholder
• Some portion of distributions may be classified as return of capital:
  • Not taxed when received
  • Instead, it reduces the investor's cost basis
  • When the investor eventually sells, the lower cost basis results in a larger taxable gain

Why REIT Dividends Are Not "Qualified"

This comes up frequently on the exam:

• Qualified dividends receive preferential tax rates (lower capital gains rates)
• To qualify, the paying corporation must have already paid corporate tax on the income
• Since REITs do not pay corporate tax (thanks to the 90% distribution rule), their dividends do not qualify for the lower rate
• Result: REIT dividends are taxed at the shareholder's ordinary income tax rate

Exam Tip: Gotchas

Return of capital distributions from a REIT are NOT free money. While they are tax-deferred when received, they reduce your cost basis. When you sell, you'll owe more in capital gains. The tax is deferred, not eliminated.

Let's wrap up the REIT section by looking at the overall investment characteristics that make REITs attractive, and risky.