Understanding REITs: A Guide to Tax-Efficient Real Estate Investing

Investing in real estate is widely recognized as one of the most effective strategies for building long-term wealth. It provides a tangible asset that not only serves as a portfolio diversifier but also tends to move independently of the volatility in the stock and bond markets. However, for many investors, the idea of purchasing and managing multiple properties can be overwhelming.

For those seeking the benefits of real estate without the complexities of direct ownership, Real Estate Investment Trusts (REITs) have garnered untapped attention in recent years on the heels of the Tax Cuts and Jobs Act of 2017. In addition to their convenience and accessibility, REITs offer several tax benefits that further enhance their appeal.

What is a Real Estate Investment Trust?

Established by Congress in 1960, a REIT is a type of company that was created to broaden access to the real estate market, allowing individual investors to participate in large-scale, income-producing properties. By pooling funds from multiple investors, REITs enable the acquisition, operation, and financing of diversified real estate portfolios, including office buildings, warehouses, shopping malls, hotels, apartment complexes, and other types of real estate.

To maintain their status, REITs are required by the IRS to:

• distribute at least 90 percent of their taxable income to shareholders
• invest at least 75 percent of total assets in real estate or cash
• receive at least 75 percent of gross income from real estate (rent, mortgage interest, or sales)
• have a minimum of 100 shareholders after the first year of establishment
• have no more than 50 percent of shares held by five or fewer individuals

REIT Dividend Tax Treatments

When investors receive dividends from a REIT, these payouts stem from various sources, each generating its own tax consequences. The bulk of REIT dividends typically comes from the company’s operating profits, which are taxed as ordinary income at the investor’s marginal tax rate. However, dividends can also include portions classified as capital gains when the REIT sells a property at a profit. If the property or REIT shares are held for more than a year, these gains are taxed at lower long-term capital gains rates, which are generally more favorable than ordinary income rates.

Additionally, some dividends are considered a return of capital (ROC), which is not taxed immediately but instead reduces the investor's cost basis in the REIT. By lowering taxable income in the short term, ROC provides tax deferral benefits, though it may result in a higher capital gains tax when the shares are eventually sold. Investors interested in deferring capital gains taxes might also explore the benefits of a 1031 exchange. For more details on this option, check out our blog on 1031 Exchange Rules for Real Estate Investors in Arizona. To manage this potential impact, investors can employ a tax-loss harvesting strategy with other assets in their portfolio. By realizing losses from other investments in your portfolio, you can use those losses to offset the capital gains generated from selling your REIT shares, and any excess losses can be carried forward indefinitely on your federal tax return, though state regulations may differ.

REIT Tax Benefits

Section 199A Qualified Business Income Deduction

Investors in REITs can take advantage of the Section 199A Qualified Business Income (QBI) deduction, which allows them to deduct up to 20 percent of their pass-through business income from REIT dividend income. This tax-friendly break lowers the taxable portion of REIT income, providing immediate savings to individual investors.

Unless Congress acts to extend this provision from the TCJA, the QBI deduction is slated to expire at the end of 2025. If not extended, investors may lose this game-changing tax advantage, potentially increasing their tax liabilities on REIT income in the future.

No Double Taxation

Unlike regular corporations that are taxed on their earnings before distributing dividends, REITs avoid double taxation. They do not pay corporate income taxes, meaning investors are only taxed on the dividends they receive.

Depreciation Deductions

REITs can claim depreciation on the properties they own, thereby reducing their taxable income. This allows REITs to preserve more of their earnings for distribution, indirectly benefiting shareholders by potentially increasing the amount available for dividends without inflating tax liabilities.

Simplified Multi-State Taxation and Foreign Investor Benefits

US investors can access a diversified national portfolio without the hassle of multi-state tax filings. Unlike direct property ownership, where taxes must be filed in each state, dividends for individual or trust shareholders are generally taxed only in their home state, avoiding additional state liabilities. Additionally, REITs offer unique tax benefits for foreign and tax-exempt investors, enhancing their appeal as a globally efficient investment vehicle.

Next Steps

REITs offer a sophisticated and tax-efficient approach to real estate investing. By understanding the unique benefits, potential risks, and evolving tax landscape, investors can strategically incorporate REITs into their diversified portfolios. To further explore the tax benefits and risks of real estate investments, check out our blog on Tax Benefits and Risks to Consider in Real Estate Investments. While the complexities of REITs may require careful consideration, the potential for long-term capital appreciation and income generation make them a compelling investment option for those seeking exposure to the real estate market.

Contact your R&A advisor to discuss tax-efficient real estate investing as it relates to your situation.