The pass-through deduction applies to REIT dividends
The part of REIT distributions that's considered ordinary income qualifies for the pass-through tax deduction from the Tax Cuts and Jobs Act.
Also known as the Qualified Business Income (QBI) deduction, this allows up to 20% of taxpayers’ income from pass-through entities to be deducted.
Being able to take the full deduction is subject to income restrictions, so be sure to look into the details before you claim the deduction. It’s also worth noting that tax-preparation software will likely apply this deduction for you. If you do your return by hand, make sure to take this deduction -- it can save you a lot of money in REIT dividend taxes.
REITs make fantastic retirement investments
The hands-down best way to avoid taxes on REIT investments is to hold them in tax-advantaged retirement accounts such as IRAs.
In retirement accounts, you don’t need to worry about paying dividend taxes each year, nor do you need to worry about capital gains taxes when you sell stocks. Since most REIT dividends are considered ordinary income and there’s also the "return of capital" element of REIT dividends that can increase your capital gains taxes, REITs make ideal candidates to hold in retirement accounts. If you have to choose between keeping REITs or standard dividend stocks in your retirement accounts, REITs are likely the better choice.
Holding your REITs in retirement accounts allows you to reinvest 100% of your dividends, which is essential for maximizing long-term compounding power.
If you hold your REITs in a traditional IRA or another tax-deferred retirement account, you won’t have to pay any taxes until you withdraw money from the account. Traditional IRA contributions are generally tax-deductible, so traditional IRA withdrawals are taxable income.
On the other hand, if your REITs are in a Roth IRA or another after-tax retirement account, you won’t have to pay a dime of tax on your REIT profits, even when making qualified withdrawals. Because you don’t get a tax deduction when contributing to a Roth IRA, you've already paid tax on your contributed money and your withdrawals are 100% tax-free -- even if your REIT holdings are worth significantly more than you paid for them.
The key takeaways on REIT dividend taxation
REITs are already tax-advantaged investments, as they're exempt from corporate income taxes on their profits. This is because REITs have to distribute most of their income to shareholders and are considered pass-through entities.
If you hold your REITs in a standard (taxable) brokerage account, most of your REIT dividends will be treated as ordinary income. However, it’s possible that some portion of your REIT dividends will meet the IRS definition of qualified dividends, and that some could be considered a non-taxable return of capital.
REIT dividends that are considered ordinary income meet the criteria for the new Qualified Business Income deduction. This allows for as much as 20% of your REIT distributions to be taken as a tax deduction.
The best way to avoid paying taxes on your REITs is to hold them in tax-advantaged retirement accounts, including traditional or Roth IRAs, SIMPLE IRAs, SEP-IRAs, or another tax-deferred or after-tax retirement accounts.
If you put these tips to use, you can save yourself hundreds or thousands of dollars on your investment taxes.