Real estate investment trusts (REITs) are known for their higher-than-average dividend yields, and thanks to the fact that real estate tends to increase in value over time, REITs can also be excellent ways to grow your money over time.
In addition, REITs also have some pretty valuable tax advantages that can help make them better long-term total return investments and save investors money on their tax bills every year in the meantime. In this article, we'll take a look at the key tax advantages of real estate investment trust investing and why these REIT tax benefits can be so important.
REITs have one big tax advantage investors need to know
There are several requirements for a company to be formally classified as a REIT by the IRS, but the best known is that REITs are required to distribute at least 90% of their taxable income to shareholders.
If they do this, REITs are treated as pass-through businesses. Why should investors care? Because pass-through businesses don't pay any corporate tax on their profits whatsoever.
This is similar to how LLCs and partnerships work. For example, if you own a business through an LLC, the profits the business makes are passed through to you and reported as personal income. The IRS doesn't assess corporate income tax.
This is a powerful benefit for REIT investors. Think of it this way -- if Apple (NASDAQ: AAPL) earns a profit, it pays corporate tax on it (currently, a rate of 21%). Then, when it distributes some of its profits to shareholders in the form of dividends, those dividends are taxed again on the individual level. In a nutshell, with most dividend stocks, the same corporate profits can effectively be taxed twice.
REITs in IRAs: A double tax benefit
In fact, the tax treatment of REITs by the IRS makes them ideal candidates for IRAs and other retirement accounts. For one thing, because REITs are considered pass-through investments, their dividends are typically considered ordinary income (not qualified dividends) and therefore are taxable at whatever your marginal tax rate (tax bracket) is. In retirement accounts, there is no dividend tax due at the end of the year, nor is there any capital gains tax due on investor profits from the sale of any investment. In a traditional IRA, you won't pay a penny of tax until you withdraw, and in a Roth IRA, qualified withdrawals are not taxable at all.
This is a unique double tax advantage for retirement investors. Not only does REIT income avoid taxes on the corporate level, but if you hold your publicly traded REIT investments in the right account type, REIT distributions can avoid tax liability entirely. This can help your REIT dividends compound much more over long periods of time, as you can reinvest your entire distribution, not just what's left over after paying taxes.
The QBI deduction applies to REIT investors
One tax disadvantage of REIT investing is that their dividends generally don't meet the IRS definition of "qualified dividends," which would entitle them to beneficial tax rates.
However, REIT dividends are officially considered to be pass-through income to the shareholder, so they qualify for the qualified business income, or QBI deduction, that was formed as part of the Tax Cuts and Jobs Act and went into effect for the 2018 tax year.
You can read our guide to the QBI deduction for more information, but the general idea is that taxpayers are allowed to deduct as much as 20% of their pass-through income from businesses they own as pass-through entities like LLCs, partnerships, and yes -- dividends they receive from REITs.
For example, let's say that you receive $1,000 in REIT dividends in a standard (taxable) brokerage account in 2021. You may be able to deduct 20% of that amount, meaning that only $800 of your REIT dividend income would be taxable. So, while REITs miss out on the qualified dividend treatment, the QBI deduction can certainly help offset this.
The Millionacres bottom line on REIT tax advantages
Real estate investment trusts aren't just excellent ways to generate income and growth. They also have some excellent tax advantages that put investors in a better position to achieve superior long-term returns and also save money each year when filing their taxes.