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.
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. You can read our guide to the 2021 U.S. income tax brackets to find your specific tax rate, but the key takeaway is that it's fair to assume most of your REIT distributions will be taxed in this manner.