The Basics of REIT Taxation

Fact checked by Michael LoganReviewed by Chip StapletonFact checked by Michael LoganReviewed by Chip Stapleton

Real estate investment trusts (REITs) are a popular way for investors to own income-generating real estate without having to buy or manage property. Investors like REITs for their generous income streams. To qualify as a REIT, the trust must distribute at least 90% of its taxable income to shareholders. In turn, REITs typically don’t pay corporate income taxes because their earnings have been passed along to investors as dividend payments.

While a steady flow of payments may sound enticing, REIT dividends come with unique tax consequences for investors. These payments can constitute ordinary income, capital gains, or a return of capital—each of which receives different tax treatment. Below, we explain how REITs work and what investors should know about the potential tax implications.

Key Takeaways

• A real estate investment trust (REIT) is a company that owns and operates income-producing real estate, allowing investors to gain exposure to the real estate market without directly owning properties.
• By law, REITs must distribute at least 90% of their taxable income to shareholders.
• This means most dividends investors receive are taxed as ordinary income at their marginal tax rates rather than lower qualified dividend rates.
• Any profit is subject to capital gains tax when investors sell REIT shares.

Basic Characteristics of REITs

REITs trace to 1960 when the U.S. Congress introduced them through an amendment to the Cigar Excise Tax Extension. This financial instrument was designed to make real estate investing more accessible, allowing average investors to participate in large-scale property portfolios previously available only to wealthy individuals and institutions.

REITs function similarly to mutual funds but focus on real estate rather than stocks and bonds. They pool capital from many investors to acquire, manage, and develop diverse types of properties. Investors can benefit from REITs in two primary ways: regular dividend payments and potential appreciation of the REIT’s share value.

The versatility of REITs is evident in their wide range of properties. From apartment complexes and office buildings to more specialized assets like data centers, healthcare facilities, and even timberland, REITs offer exposure to virtually every sector of the real estate market. While some REITs specialize in specific property types, others maintain diversified portfolios. This flexibility allows investors to tailor their real estate exposure to their individual investment strategies and market outlooks.

As of 2024, REITs are available in more than 40 countries and have surpassed $2 trillion in market capitalization. In the U.S., REITs must pay at least 90% of taxable income to unit holders. This makes REITs attractive to investors seeking higher yields than those in traditional fixed-income markets.

Three Types of REITs

REITs generally fall into three categories:

• Equity REITs: These trusts invest in real estate and derive income from rent, dividends, and capital gains from property sales. The three sources of income make this type of REIT popular—it’s about 96% of the REIT market by capitalization.
• Mortgage REITs: These trusts invest in mortgages and mortgage-backed securities. Because mortgage REITs earn interest from their investments, they are sensitive to interest rate changes. 
• Hybrid REITs: These REITs invest in both real estate and mortgages. These have largely fallen away since the financial crisis of 2007 to 2008.

Taxation at the Trust Level

A REIT is an entity that would be taxed as a corporation were it not for its special REIT status. To meet the definition of a REIT, the bulk of its assets and income must come from real estate. In addition, it must pay 90% of its taxable income to shareholders.

This requirement means REITs typically don’t pay corporate income taxes, though any retained earnings would be taxed at the corporate level. A REIT must invest at least 75% of its assets in real estate and cash, and obtain at least 75% of gross income from sources such as rent and mortgage interest.

Taxation for Unitholders

The dividend payments REIT investors receive can constitute ordinary income, capital gains, or a return on capital. This will all be broken down on the 1099-DIV that REITs send to shareholders yearly. Generally speaking, the bulk of the dividend is income from the company’s real estate business and is treated as ordinary income to the investor. This part of the dividend is taxed according to the investor’s marginal tax rate.

The REIT may inform you that part of the dividend is a capital gain or loss. This occurs when the REIT sells property held for at least one year. The capital gain or loss is also passed along to the investor, with gains taxed at 0%, 15%, or 20%, depending on the investor’s income level for the year the gain was received.

In addition, a part of the dividend may be listed as a nontaxable return on capital. This can happen when the REIT’s cash distributions exceed earnings, for example, when the company takes large depreciation expenses. There are two things to note about a return of capital:

1. This part of the dividend is not taxable for the year it is paid to the unitholder. It’s taxed later.
2. A return of capital lowers the unit holder’s cost basis. When the investor sells their units, this payment is taxed as either a long- or short-term capital gain or loss.

If enough capital is returned to the investor and the cost basis falls to zero, any further non-dividend distributions are taxed as a capital gain.

The part of the REIT dividend attributable to income may receive further preferential tax treatment under the Tax Cuts and Jobs Act (TCJA) of 2017. The act gives a new 20% deduction for pass-through business income, which includes qualified REIT dividends. The deduction expires at the end of 2025.

Non-U.S. residents should note that their REIT income could be subject to a 30% withholding tax. A reduced rate and exemption may apply if a tax treaty exists between the U.S. and the REIT holder’s country of residence.

Example of Unitholder Tax Calculation

An investor buys shares of a REIT trading at $20 per unit. The REIT generates $2 per unit from operations and distributes 90% (or $1.80) to unit holders. Of this, $1.20 of the dividend comes from earnings. The remaining $0.60 comes from depreciation and other expenses and is considered a nontaxable return of capital.

The investor would pay ordinary income taxes on the $1.20 in the year in which it was received. Meanwhile, the investor’s cost basis is reduced by $0.60 to $19.40 per share. This reduction in basis will be taxed as either a long- or short-term gain or loss when the units are sold.

What Is the Difference between a REIT and a REIT ETF?

A REIT owns one or more properties and distributes income from those properties to investors. A REIT ETF, meanwhile, is an exchange-traded fund that owns a portfolio of different REITs.

Why Do REITs Have to Pay Large Dividends to Shareholders?

By law, REITs must pay out at least 90% of their taxable profits to shareholders as dividends. In return, REIT companies are exempt from most corporate income tax. Many REITs reinvest shareholder dividends, offering deferred taxation and compounding your gains.

How Are REITs Taxed for Ordinary Investors?

Most REIT dividends are taxed as ordinary income at the investor’s marginal tax rate rather than the lower qualified dividend rate. When an investor sells REIT shares, any appreciation is also subject to capital gains taxes. Holding REITs in tax-advantaged accounts like individual retirement accounts can defer or eliminate taxes on distributions, potentially making them more tax-efficient for some investors.

Note that some REIT distributions may be classified as a return of capital. These are not taxed immediately but instead cut the investor’s cost basis in the REIT shares. This can result in higher capital gains taxes when the shares are eventually sold.

The Bottom Line

REITs provide unique tax advantages that can translate into a steady income stream for investors and higher yields than they might earn in fixed-income markets. However, investors should know whether these payments are in income, capital gains, or a return of capital, as each is treated differently at tax time. Furthermore, qualified REIT dividends may enjoy additional tax breaks under TCJA.

Since each person’s tax situation differs, investors should consult with their financial advisor to understand how REIT dividends will impact their tax obligations.

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