Real estate investment trusts (REITs) are a popular investment vehicle for those interested in the real estate market without the direct ownership of property. However, understanding the complex tax structure is crucial for investors to make money with REITs. A financial advisor can help you figure out how this investment could fit into your portfolio. Here’s a general breakdown of the tax advantages and risks.
How REITs Work
Real estate investment trusts (REITs) are unique entities that own or finance income-producing real estate across various property sectors.
REITs are designed so that a variety of investors can fund these real estate purchases without having to put in the work of finding properties or managing them. The management team will take care of all the work in that regard while the investor just enjoys the benefits of successful investments.
When it comes to taxation, the tax burden frequently falls on the investors, who pay income tax on the dividends they receive. The tax implications of investing in REITs can vary given the type of REIT and the investor’s individual tax situation (we will explain taxes in a section below).
Understanding the Mechanics of REITs
REITs are corporations, trusts or associations that own and manage a real estate portfolio. As such, they provide avenues for individual investors to earn a share of the income produced through commercial real estate ownership or financing.
This investment essentially bridges the gap between real estate and equity investments. It allows investors to buy shares in real estate ventures like if they were buying ETFs. In this comparison, both financial investments:
- Can provide diversified exposure to a specific asset class
- Are typically traded on stock exchanges
- Can offer dividend income
Take note: While REITs can add diversity to your investment portfolio by spreading your risk across different asset classes, they can also be aggressive investments with his risk, comparable with stocks or cryptocurrency.
The Different Types of REITs
There are different types of REITs that you might be interested in investing in, depending on what you’re trying to achieve. Three common types include:
- Equity REITs own and manage real estate properties and collect rent
- Mortgage REITs lend money to real estate owners and operators either directly through mortgages/loans or indirectly through acquiring mortgage-backed securities.
- Hybrid REITs are a combination of equity and mortgage REITs.
All three types of REITs have different risk and return profiles. Therefore, you should consider your personal financial goals and risk tolerance before investing.
Understanding the Taxation of REITs
The taxation of REITs follows specific rules. Most notably, as long as a REIT distributes at least 90% of its taxable income as dividends to its shareholders, it is not required to pay any corporate income tax.
Additionally, investors might receive taxable dividends or other payouts when they cash in their ownership of the REIT, similar to how you would sell a stock.
The increase of your investment in a REIT is going to be treated pretty similarly to how an increase from a stock increase would be. This means that you’ll be paying capital gains tax on that increase and the amount you’ll pay depends on your other finances.
Take Advantage of This Tax Benefit Before It Expires
There is a current tax benefit for investing in REITs that is set to expire, at the end of the 2025 tax year. Individuals can currently deduct 20% of the pass-through income coming from REIT investments.
This can incentivize you to invest in a REIT right now as you may pay significantly less in taxes than you would have before this benefit was provided.
There is no guarantee that this tax benefit will be extended beyond 2025.
Bottom Line
REITs can provide a way for investors to participate in the real estate market and offer unique tax benefits. However, you should understand the tax implications and risks before investing to take full advantage for your portfolio.
Tips for Investing in Real Estate
- There are numerous ways to invest in real estate, including REITs. An experienced financial advisor can help you navigate the world of real estate investing and help you determine which, if any, are the best choices to help you reach your financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you canhave a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before investing in a REIT, make sure you have the right amount of money so that your investment becomes worthwhile.
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FAQs
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.
Why are REITs taxes inefficient? ›
REITs and REIT Funds
Real estate investment trusts are a poor fit for taxable accounts for the reason that I just mentioned. Their income tends to be high and often composes a big share of the returns that investors earn from them, as REITs must pay out a minimum of 90% of their taxable income in dividends each year.
What are the tax advantages of non traded REITs? ›
Unlike many companies however, REIT incomes are not taxed at the corporate level. That means REITs avoid the dreaded “double-taxation” of corporate tax and personal income tax. Instead, REITs are sheltered from corporate taxes so their investors are only taxed once.
Are REITs a good source of income? ›
One of the biggest benefits of REITs is their high-yield dividends. REITs are required to pay out 90% of taxable income to shareholders.
What is the tax loophole for REITs? ›
Tax benefits of REITs
Current federal tax provisions allow for a 20% deduction on pass-through income through the end of 2025. Individual REIT shareholders can deduct 20% of the taxable REIT dividend income they receive (but not for dividends that qualify for the capital gains rates).
What are the disadvantages of investing in REITs? ›
Investors should be aware that non-traded REITs may have high up-front fees or sales commissions. These REITS may also have annual management fees, and the management team may take a percentage of profits in the form of “promoted interest”. Together these fees can put a dent in the ultimate return that investors see.
Are REITs a waste of money? ›
Summary of Why NOT to Invest in REITs
But, REITs are not risk free. They may have highly variable returns, are sensitive to changes in interest rates, have income tax implications, may not be liquid, and fees can impact total returns.
Why should we avoid REITs? ›
When investing only in REITs, individuals incur more risk than when they are part of a diversified portfolio. REITs can be sensitive to interest rates and may not be as tax-friendly as other investments.
Can REITs go broke? ›
REIT bankruptcies have indeed been a rarity since the REIT debacle of the mid-1970s, when high leverage and highly speculative real estate investments resulted in numerous REIT failures.
How is private REIT income taxed? ›
The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37% (returning to 39.6% in 2026), plus a separate 3.8% surtax on investment income. Taxpayers may also generally deduct 20% of the combined qualified business income amount which includes Qualified REIT Dividends through Dec.
Use Form 1120-REIT, U.S. Income Tax Return for Real Estate Investment Trusts, to report the income, gains, losses, deductions, credits, certain penalties; and to figure the income tax liability of a REIT.
Are REIT dividends tax exempt? ›
By default, all dividends distributed by a REIT are considered ordinary, or non-qualified, and are taxed as ordinary income. REIT dividends can be qualified if they meet certain IRS requirements.
What is the 90% rule for REITs? ›
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
What is the 5 50 rule for REITs? ›
Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 shareholders (the 100 Shareholder Test) and five or fewer individuals cannot own more than 50% of the value of the REIT's stock during the last half of its taxable year (the 5/50 Test).
What I wish I knew before investing in REITs? ›
A lot of REIT investors will select their investments based on the dividend yield and think that a higher yield will likely lead to higher total returns. But in reality, it is often the opposite. More often than not, the lowest-yielding REITs have actually outperformed the highest-yielding REITs over the long run.
How are REITs taxed in an IRA? ›
Tax treatment: Dividends received from REITs are tax-deferred or tax-free, depending on the IRA type. The same applies to capital gains when you sell REIT assets. Prohibited transactions: The IRS has strict rules regarding prohibited transactions, which also apply to REIT investments.
Are REIT ETFs tax efficient? ›
This can result in significant tax savings for investors, especially those in higher tax brackets. Another tax advantage of REIT ETFs is that the dividends paid by the REIT are often considered qualified dividends, which are taxed at a lower rate than ordinary income.
What are the benefits of starting a REIT? ›
REITs receive special tax considerations and typically offer investors high dividend yields, as well as a liquid method of investing in real estate. REITs, which are structured as a corporation, are not typically taxed at the entity level, which allows investors to avoid double taxation on dividends.
