Tax Treatment of REIT Dividends vs Regular Stock Dividends: 5 Key Differences

Understanding the tax implications of your investments is significant for maximizing your profits and reducing potential liabilities. This is particularly true when comparing the taxation of Real Estate Investment Trust (REIT) dividends and regular stock dividends, which follow different tax regulations and offer varied benefits.

In this article, we’ll dive deep into this subject, providing a clear comparison of the tax treatment for REIT dividends and regular stock dividends, along with highlighting the 5 key differences.

What are REIT dividends and how are they taxed?

REIT dividends are the distributions made to shareholders from a Real Estate Investment Trust (REIT). REITs are companies that own, operate, or finance income-generating real estate. The unique structure of REITs requires them to distribute at least 90% of their taxable income to shareholders annually in the form of dividends. The taxation on these dividends can vary.

Generally, most REIT dividends are taxed as ordinary income up to the maximum federal rate of 37%. However, some portions might be considered qualified dividends or return on capital, which are subject to lower tax rates or are not taxed at all, respectively.

5 Key differences between tax treatment of REIT and regular stock dividends

1. Ordinary income vs. qualified dividends

REIT dividends are generally considered ordinary income and taxed at the individual’s regular income tax rate, which can be as high as 37%. Regular stock dividends from corporations, on the other hand, are often qualified dividends, taxed at a maximum rate of 20%, provided certain holding period requirements are met. This difference can significantly impact the net return on your investment.

2. Non-Deductible Portion

A part of REIT dividends may be classified as return of capital, which is not immediately taxable. Instead, it reduces the cost basis of the REIT shares, and tax is deferred until the shares are sold. This can provide a tax advantage compared to regular stocks, where dividends do not reduce the cost basis of the shares.

3. Dividend Reinvestment Plans (DRIPs)

Some REITs offer Dividend Reinvestment Plans (DRIPs), allowing investors to reinvest their dividends back into additional shares or fractional shares instead of receiving cash payouts. This is also available with some regular stocks, but an advantage with REITs is that it may allow for more effective compounding due to the typically higher dividend yield.

4. Section 199A Deduction

The Tax Cuts and Jobs Act introduced a new tax deduction in 2018 – the Section 199A deduction, which allows taxpayers to deduct up to 20% of qualified business income from REIT dividends. This effectively reduces the top tax rate on this income to 29.6%. This deduction is not available for regular stock dividends.

5. Foreign withholding tax

For U.S. investors owning foreign REITs, the foreign withholding tax on dividends can be higher compared to regular foreign stock dividends due to differences in international tax treaties. Always check withholding tax rates before investing to ensure you’re aware of the full tax implications.

Why is there a difference in the tax treatment of REIT dividends and regular stock dividends?

The difference in the tax treatment of REIT dividends and regular stock dividends arises from the unique structure and regulations governing REITs. REITs are required to distribute at least 90% of their taxable income to shareholders annually. This structure is designed to allow these companies to avoid paying corporate income tax, thus preventing the double taxation that typically occurs with regular corporations – once at the corporate level and again when profits are distributed as dividends to shareholders.

As a result, REIT dividends are generally considered non-qualified and taxed as ordinary income, while regular stock dividends can be classified as qualified dividends and taxed at the lower capital gains rate. However, certain portions of REIT dividends may be treated differently, such as return of capital or Section 199A dividends, leading to varied tax implications for investors.

How are non-qualified dividends taxed compared to REIT dividends?

Non-qualified dividends are taxed at the individual’s regular income tax rate, similar to how wages or other ordinary income are taxed. Depending on the individual’s tax bracket, the tax rate applied to non-qualified dividends can range from 10% to 37%. This type of dividend does not meet the criteria set by the IRS to be considered a qualified dividend, and thus does not benefit from the lower tax rates that qualified dividends enjoy.

On the other hand, most REIT dividends are also taxed as ordinary income at the individual’s regular tax rate, mirroring the tax treatment of non-qualified dividends. However, there are exceptions within REIT dividends that could change this tax treatment. For example, some portions of REIT dividends might be treated as return of capital, which isn’t immediately taxable.

Instead, it reduces the cost basis of the REIT shares and defers tax until the shares are sold. Some REIT dividends may be classified as qualified business income, which could potentially qualify for a 20% deduction under Section 199A of the IRS code. This can lower the effective tax rate for those portions of the dividends.

Do REIT dividends qualify for preferential tax treatment?

Certain portions of REIT dividends do qualify for preferential tax treatment. While most REIT dividends are taxed as ordinary income, some may be classified as return of capital or Section 199A dividends. Return of capital is not immediately taxable and reduces the cost basis of the shares, deferring the tax until the shares are sold.

Section 199A dividends, introduced by the Tax Cuts and Jobs Act, may allow investors to deduct up to 20% of their qualified business income from REITs, effectively reducing the top tax rate on this income.

However, these benefits depend on the individual’s specific circumstances and tax laws, which can change. It’s always best to consult with a tax professional for personalized advice.

Why are REIT dividends taxed as ordinary income?

REIT dividends are taxed as ordinary income due to the structure and regulations governing Real Estate Investment Trusts (REITs). REITs are required to distribute at least 90% of their taxable income to shareholders annually. This prerequisite is designed to allow REITs to avoid paying corporate income tax.

As a result, the burden of tax is shifted to the shareholders who receive these distributions. Unlike typical corporate dividends which may qualify for lower capital gains tax rates, most REIT dividends do not meet the criteria for qualified dividends and are therefore taxed at the individual’s regular income tax rate. However, certain exceptions like return of capital or Section 199A dividends might alter the tax implications.

What is the role of dividends paid deduction in REIT taxation?

Under U.S. tax law, REITs can deduct the dividends they pay to shareholders from their corporate taxable income. This is a significant aspect of the REIT structure as it allows these entities to avoid paying corporate income tax, assuming they meet certain requirements, including distributing at least 90% of their taxable income to shareholders.

By offering this deduction, the tax code effectively shifts the tax obligation from the REIT itself to the individual shareholders. The shareholders then pay tax on the dividends received at their individual tax rates. This dividends paid deduction is a unique feature of REITs and is instrumental in preventing the double taxation that typically occurs with regular corporations.

What is the tax treatment of REIT dividends in tax-deferred accounts?

REIT dividends received in tax-deferred accounts, such as Individual Retirement Accounts (IRAs) or 401(k) plans, are not immediately taxed. The dividends can be reinvested and compound over time without incurring taxes on the income or capital gains.

Taxes are only due when distributions are taken from the account, typically in retirement. At that point, the distributions are taxed as ordinary income, regardless of the source of the original income within the account.

This can provide a significant advantage for REIT investors, as the typically higher REIT dividend yields can compound tax-free over time.

What are the implications of the highest tax bracket on REIT dividends?

The highest tax bracket can significantly impact the net return from REIT dividends. In the U.S., the highest tax bracket for individuals is currently 37%. Since most REIT dividends are taxed as ordinary income, they are subject to this rate if the shareholder’s income falls into this bracket.

This is in contrast to qualified dividends from regular stocks, which are subject to a maximum tax rate of 20%. However, portions of REIT dividends may be classified as return of capital or Section 199A dividends, which can alter this tax treatment.

Return of capital is not immediately taxable, and Section 199A dividends may allow for a deduction of up to 20% of the dividend income, effectively reducing the top tax rate on that portion. Nonetheless, investors in the highest tax bracket should consider these tax implications when investing in REITs.

Is there a way to avoid or defer paying taxes on REIT dividends?

  • Invest through a tax-deferred account: REITs can be held in tax-deferred accounts like IRAs or 401(k) plans. Dividends received in these accounts are not taxed until you take distributions, which is typically during retirement.
  • Reinvest through a Dividend Reinvestment Plan (DRIP): Some REITs offer DRIPs, which allow dividends to be reinvested in additional shares instead of receiving cash payouts. While this does not avoid taxes, it can help grow your investment more quickly.
  • Take advantage of return of capital: Part of a REIT dividend may be classified as return of capital, which is not immediately taxable. Instead, it reduces the cost basis of the REIT shares, and tax is deferred until the shares are sold.
  • Utilize the Section 199A Deduction: The Section 199A deduction allows for a deduction of up to 20% of qualified business income from REIT dividends, effectively reducing the taxable amount.

Can the taxation of REIT dividends influence investment decisions in REITs?

The taxation of REIT dividends can significantly influence investment decisions in REITs. Understanding the tax implications is crucial to accurately assessing the net return on investment. For instance, while REITs often offer higher dividend yields compared to regular stocks, most REIT dividends are taxed as ordinary income at potentially higher rates.

This could lower the net return for investors in higher tax brackets. However, certain portions of REIT dividends may receive preferential tax treatment, such as return of capital or Section 199A dividends.

Furthermore, holding REITs in tax-deferred accounts can allow the dividends to compound tax-free over time. Therefore, investors need to consider their individual tax situations and possibly consult with a tax professional when making investment decisions regarding REITs.

How can investors benefit from owning REIT shares in a retirement account?

  • Tax-deferred growth: REIT dividends received in retirement accounts like 401(k)s and IRAs are not immediately taxed. The dividends can be reinvested and grow tax-free until you start taking distributions.
  • No immediate tax on dividends: Unlike taxable accounts, dividends earned within a retirement account are not subject to immediate taxation. This means that the full amount of dividends can be reinvested, leading to potentially faster compounding and growth.
  • Flexibility in distributions: Distributions from retirement accounts are typically made during retirement when income, and potentially tax rates, may be lower. This can provide tax advantages over the long term.
  • Potential for higher yield: REITs often have higher dividend yields compared to many traditional stocks, providing a steady stream of income that can compound over time within a retirement account.
Alice
Author: Alice