How are REITs Dividends Taxed?
The two most well-known characteristics of REITs are that they typically do not pay corporate income taxes and pay relatively significant dividends.
For IRS purposes, a REIT must pay its common and preferred shareholders dividends that total at least 90% of the amount that would otherwise be subject to ordinary income tax in order to qualify as a REIT each year.
A REIT that distributes just 90% of its taxable revenue will have to pay corporation taxes on the remaining 10%. REITs are exempt from paying corporate income taxes if they pay a dividend equivalent to 100% of their taxable income (including capital gains) and meet all other REIT standards. Shareholders in REITs pay the applicable taxes on their dividend income.
When a partnership distributes money to its partners, the entity credits to cash and debits equity to report the decrease in cash and the decrease in the capital account balance of the partner; similarly, when a REIT distributes profits by paying dividends, the entity credits cash but then debits the income statement, lowering its corporate taxable income by the distribution.
Due to their obligation for a minimum distribution of 90%, REITs have greater dividend payment ratios than C-corporations that are not REITs.
In reality, non-REIT C-corps have the option of forgoing dividend payments to shareholders.
REIT management teams often manage their portfolios (what they hold and where they are located) and balance sheets cautiously in order to sustain and/or raise the dividend since REITs must meet their minimum distribution obligation.
REITs have the option to lower or eliminate their common dividends, but only after suffering significant short-term stock price performance losses. The way dividends are taxed at the investor level has changed as a result of changes to the tax code since 2000.
The Bush Tax Cuts, also known as the Jobs and Growth Tax Relief Reconciliation Act of 2003, reduced the individual tax rate on previously taxable C-corporation earnings distributed to shareholders as eligible dividends to a maximum of 15%. (Note that the highest tax bracket now has a 20% rate according to the American Taxpayer Relief Act of 2012.)
According to the Bush Tax Cuts and the IRS, dividends received from non-REIT C-corps are subject to both corporate and investor taxes, and they may be taxed at the investor’s capital gains rate. Earnings from REITs are not subject to the “double taxation” that applies to dividends from other C-corps.
The portion of a REIT dividend that is classified as ordinary taxable income is not eligible for the reduced tax rate since it is not taxed at the corporate level, making REIT dividends non-qualified dividends under this legislation.
The part of REIT dividends that are classified as ordinary taxable income continues to be non-qualified and taxed at an investor’s ordinary income tax rate as a result of changes made by the Tax Cuts and Jobs Act of 2017 (also known as the Trump Tax Cuts of 2017).
However, Section 199A of the 2017 Trump Tax Cuts permits investors to write off up to 20% of their total qualified REIT dividends. A qualified REIT dividend is one from a REIT that is not a capital gain dividend or qualified dividend income, as specified in Section 199A(e)(3) of the 2017 Trump Tax Cuts. Simply put, taxes are not due on the first 20% of a REIT payout that is considered regular income.