To qualify as a REIT with the IRS, a real estate company must agree to pay out at least 90% of its taxable profit in dividends (and fulfill additional but less important requirements). By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on its entire profit and then decides how to allocate its after-tax profits between dividends and reinvestment; a REIT simply distributes all or almost all of its profits and gets to skip the taxation.
The IRS requires REITs to pay out at least 90% of their incomes to unitholders (the equivalent of shareholders). This is similar to corporations and means REITs provide higher yields than those typically found in the traditional fixed-income markets. They also tend to be less volatile than traditional stocks, because they swing with the real estate market.
REITs must follow the same rules as all other unit investment trusts. This means that REITs must be taxed first at the trust level, then to beneficiaries. But they must follow the same method of self assessment as corporations. So, REITs have the same valuation and accounting rules as corporations, but instead of passing through profits, they pass cash flow directly to unitholders.
There are a few extra rules for REITs beyond the rules for other unit investment trusts. They are:
- Rental income is treated as business income to REITs because the government considers rent to be the business of REITs. This means that all expenses related to rental activities can be deducted the same as business expenses can be written off by a corporation.
- Furthermore, current income that is distributed to unitholders is not taxed to the REIT, but if the income is distributed to a non-resident beneficiary, then that income must be subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains, unless the rate is lower by treaty.
For all practical purposes, REITs are generally exempt from taxation at the trust level as long they distribute at least 90% of their income to their unit holders. However, even REITs that adhere to this rule still face corporate taxation on any retained income.
The dividend payments made out by the REIT are taxed to the unitholder as ordinary income - unless they are considered to be "qualified dividends," which are taxed as capital gains. Otherwise, the dividend will be taxed at the unitholder's top marginal tax rate.
Also, a portion of the dividends paid by REITs may constitute a nontaxable return of capital, which not only reduces the unit holder's taxable income in the year the dividend is received, but also defers taxes on that portion until the capital asset is sold. These payments also reduce the cost basis for the unitholder. The nontaxable portions are then taxed as either long- or short-term capital gains/losses.
Because REITs are seldom taxed at the trust level, they can offer relatively higher yields than stocks, whose issuers must pay taxes at the corporate level before computing dividend payout.
Example - Unitholder Tax Calculation
Jennifer decides to invest in an REIT that is currently trading at $20 per unit. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholders. However, 60 cents per unit of this dividend comes from depreciation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($1.80 - 60 cents) of this dividend comes from actual earnings.
This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by 60 cents to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a long- or short-term gain/loss when the units are sold.
The unique tax advantages offered by REITs can translate into superior yields for investors seeking higher returns with relative stability. Theoretically, it is possible for a unitholder to achieve a negative cost basis if the units are held for a long enough period of time. While this is hardly common, the potential for realizing a possible gain or loss in this manner should be clearly understood by investors.
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