What Is the REIT Dividend Tax Rate?

Dividends from real estate investment trusts, or REITs, are considered taxable income in the eyes of the IRS, but there's much more to the story than that. There's no single tax rate that is applied to REIT dividends, and in fact, the same REIT dividend could be made up of several different kinds of income. When holding REITs in a taxable account, it's best to understand these three types of income -- and their tax consequences.

So, REITs have a somewhat complicated tax structure when it comes to their dividends. But we're here to make it as simple as possible. Here's an overview of how REIT dividends are taxed, a real-world example of how it works, and where to find the exact tax rates that will apply to your REIT dividends.

REIT dividends can be complicated

Does a REIT dividend meet the IRS definition of a qualified dividend, or is it considered ordinary income? The answer could be yes to both.

In most cases, REIT dividends are made up of as many as three different types of income:

• Ordinary income: Most rental income generated by REITs and passed through to investors is considered ordinary income, just as if it had been earned through an LLC or partnership and passed through to an owner.
• Qualified REIT dividends: Depending on how a REIT made its money for a certain time period, a portion (usually a small one) of the dividend distributions can be considered a qualified dividend. These may also be referred to as capital gain distributions.
• Return of capital: If a portion of a REIT's income comes from selling assets, some of its distributions can be considered a return of investor capital, which is not taxable. However, it's important to note that a return of capital serves to lower the investors' cost basis, which could result in higher capital gains tax when shares are eventually sold. Some REITs refer to these simply as nontaxable distributions.

How most REIT dividends are taxed

In the vast majority of cases, REIT distributions are mostly made up of ordinary income and are therefore taxable at the investor's marginal tax rate, or tax bracket. But the key takeaway is that it's fair to assume most of your REIT distributions will be taxed in this manner.

The QBI deduction

While most REIT dividends are taxable as ordinary income, they also get one very valuable tax break for investors who qualify. It all comes back to a REIT's fundamental form as an investor-owned real estate portfolio.

Specifically, REIT dividends are generally considered to be pass-through income, similar to money earned by an LLC and passed through to its owners. The Tax Cuts and Jobs Act created a tax deduction called the qualified business income deduction, or QBI deduction for short. Often referred to as the pass-through deduction, this allows taxpayers to deduct as much as 20% of their income that comes from pass-through sources. And ordinary income distributions from REITs qualify.

Qualified REIT dividends get favorable treatment

In the event that a portion of a REIT's distributions meet the IRS definition of qualified dividends, it is entitled to favorable tax treatment. Check out our guide to qualified dividend taxes if you want to see your specific tax rate, but this is the same tax structure that applies to long-term capital gains.

Investors should note that REIT dividends received in a qualified retirement account, such as an IRA, will not offer the same benefits. When it comes to tax advantages, the IRS typically doesn't allow taxpayers to double dip.

The bottom line

To sum it up, REIT dividends can be rather complicated for tax purposes. The bulk of REIT dividends are typically considered to be ordinary income but are also entitled to the pass-through deduction. Some REIT dividends might meet the requirements for qualified dividend tax treatment, and a portion could be considered a non-taxable return of capital. Of course, investors can avoid all of this tax complication by investing in REITs through a tax-advantaged retirement account like an IRA. But if you do hold any REITs in taxable brokerage accounts, it's important to realize that their tax treatment isn't exactly as straightforward as that of most other dividend stocks.