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Real Estate Investment Trusts (REITs) generally have high yields, making them popular choices for dividend investors. Although REITs trade on exchanges like stocks, the tax structure for these investments can be much different.
For a basic guide on REITs, be sure to check out The Definitive Guide to Real Estate Investment Trusts.
For a company to qualify as a REIT, 75% of its assets must be in the form of real estate. These companies allow investors to invest in real estate without purchasing property. REITs are not required to pay income taxes, but must distribute at least 90% of their profits to shareholders in the form of dividends. This policy results in high yields for shareholders, but also higher tax obligations.
See our complete list of REITs here.
Since REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends, companies are able to offer investors a much higher dividend than regular stocks.
The average dividend yield for a REIT is over 5%, while the average stock yield is around 3%. REITs can be a great option for investors seeking significant dividend income and exposure to real estate.
Learn about other Dividend Friendly Industries.
However, these high yields come with higher tax expenses than regular stocks. Since corporations that operate as REITs are not required to pay income tax, the tax obligations are passed on to the shareholders.
Most REIT distributions are considered non-qualified dividends, which means that they do not qualify for the capital gains tax rate. In most cases, an individual will have a 15% capital gains rate on qualified dividends and will be charged their regular income tax rate for non-qualified dividends.
The ObamaCare Surtax
As of January 2, 2013, the dividend and capital gains tax rate is 20% for investors making over $400,000 and households making over $450,000. Please refer to the table below:
|Ordinary Tax Rate||Qualified Dividends||Non-Qualified Dividends|
Unrelated Business Taxable Income (UBTI)
Unrelated Business Taxable Income (UBTI) is a tax from unrelated business activities that would otherwise be tax free. REITs generally try to lower the amount on UBTI to their shareholders, making this tax rare for shareholders.
While owning a REIT in an open account will result in unfavorable tax rates, an IRA, Roth IRA or 401(k) can be much more tax friendly. While finding a tax friendly retirement account, it is important to know to key differences in Traditional and Roth IRAS.
Roth Vs. Traditional IRA
Both Roth and Traditional IRA accounts offer significant tax breaks. A Traditional IRA allows investors to receive a tax break in the year that the investment is made, but it requires the investor to pay taxes when the money is withdrawn. A Roth IRA has no immediate tax breaks for investors, but it’s tax free when the money is withdrawn.
For an investor who expects to have a lower tax bracket when they withdraw money, a traditional IRA is probably the best choice. This gives the investor an immediate tax break. On the other hand, an investor who expects to be in a higher tax bracket when the money is withdrawn, a Roth IRA may be a better choice since withdrawals are tax free after the age of 59 and a half.
Click here for more information on Roth and Traditional IRAs.
REITs in 401(k) Plans
For investors that do not want to own individual REITs in their IRA, adding exposure to real estate in a 401(k) plan can be a great way to add diversity to a retirement portfolio in a tax efficient way. There are many mutual funds and ETFs available that have REIT exposure.
Click here for a complete list of REIT-focused ETFs.
REITs & Dividend Reinvesting
Dividend ReInvestment Programs (DRIPs) are a great way to grow your dividend investment at a low cost or no cost at all. Many REITs have created DRIP programs for investors. For REITs that do not have these programs, many major brokers have this option available. However, it is important to understand that a DRIP program will not defer or eliminate any taxes unless the REIT is in a tax efficient account like an IRA.
Be sure to read this Simple Guide to Understanding 401(k)s.
For yield-starved investors, REITs offer a lucrative antidote as they are inherently structured to deliver a regular stream of current income. For most investors, holding REITs in tax-sheltered accounts is the ideal approach to minimizing their tax burden. With that being said, there is a number of other considerations and nuances to take into account before making an allocation, so be sure to do your homework first.