To be classified as a real estate investment trust, or REIT, a company must meet strict requirements. For one thing, it needs to invest at least 75% of its assets in real estate. It also has to derive at least 75% of its income from these assets. In addition, REITs must have at least 100 shareholders and no five shareholders can control a majority of a REIT’s outstanding shares.
Perhaps the most well-known of the REIT requirements is that it must pay out at least 90% of its taxable income to shareholders. Most REITs end up paying out all of it.
Which is great. But it comes with some tax implications that you need to know.
How REITs are taxed
Because of this last requirement, REITs are treated as pass-through entities for tax purposes. LLCs and partnerships are also pass-throughs. Imagine that you and two business partners own a convenience store. Your proportional share of the business’ income is passed to you and you’ll report it as income on your individual tax return.
As a pass-through business, a REIT's profits aren't taxed on the corporate level. It doesn’t matter if the REIT’s profits are in the billions -- as long as it meets the REIT requirements, it won’t pay a dime in corporate taxes.
This is a huge benefit for REIT investors. With most dividend-paying stocks, profits are effectively taxed twice. First, the company pays corporate tax on its earnings (currently taxed at a 21% rate). Then shareholders are taxed again when these profits are paid out as dividends.
To be fair, REITs aren’t completely tax-exempt. They still pay property taxes on their real estate holdings, for one thing. And there are some situations where REITs need to pay income taxes.
REIT dividends can be complicated
REITs enjoy a simple tax structure on the corporate level. But when it comes to individual taxation of REIT dividends, it's more complicated.