With most stocks, taxation is fairly straightforward. Company profits are subject to corporate taxes and dividends paid are typically subject to qualified dividend tax rates.
When it comes to real estate investment trusts, or REITs, taxation is a bit more complicated. Not only can REITs avoid corporate tax altogether, but REIT dividends have a complex tax treatment you should know about before buying shares.
Here's a quick guide to REIT taxation and how investors should invest if they want to avoid the tax complications that come with REIT investing.
REITs don't pay any corporate tax
When it comes to stock investing, there are two types of taxation you should know.
First, there are individual taxes that you'll pay on dividends and capital gains tax you pay when you sell for a profit.
Second, there are corporate taxes which may be assessed on a company's profits before the company distributes income to shareholders. These are only indirectly related to your earnings, but they're worth considering.
REIT taxation is a special case. In exchange for meeting certain requirements -- in particular, paying at least 90% of their taxable income to shareholders as dividends -- REITs pay no corporate tax whatsoever.
Instead, REITs are treated in the same manner as pass-through business entities like LLCs, partnerships, and S-corporations. This is one of the biggest tax advantages of REIT investing.
REIT dividends can be a bit complicated
While the lack of corporate tax is certainly a perk, REITs aren't tax-advantaged investments in every way. Especially when it comes to dividends. REIT dividends typically don't qualify for the favorable tax treatment most stock dividends do. And their dividends can be rather complex. Specifically, there are three main types of distributions REITs make -- ordinary income, long-term capital gains, and return of capital -- and each one has a different tax treatment.
Most of the money distributed by REITs is considered ordinary income. Generally speaking, any distributed operating profit is considered to be an ordinary dividend. This is important for REIT taxation.
For the most part, REIT dividends don't meet the definition of a "qualified" dividend. In a nutshell, this means REIT income taxation is at your marginal tax rate, or tax bracket. (You can check out our guide to the 2019 tax brackets if you're unsure of yours.)