REITs Explained: How They Work and How Their Income Is Taxed

Alpha Sentinel is a software platform, not a registered investment adviser. This article is educational, not investment advice. Full disclaimer at the end of this post.

A distribution from a real estate fund lands in your account on a Friday, and the tax form that follows months later has three different boxes for it. If you own a REIT, that moment is common, and it raises two fair questions: where does the money come from, and why is it taxed that way? A REIT, or real estate investment trust, is a company that owns or finances income-producing real estate and is required to pass most of its taxable income to shareholders. The tax treatment follows from that structure, and once you see the structure, the paperwork stops being mysterious.

Key Takeaways

• A REIT is a company that owns or finances real estate and must meet tests set by the tax code, including distributing most of its taxable income.
• REITs earn money mainly from rent and, for mortgage REITs, from interest on real estate loans.
• Distributions are usually a mix of ordinary income, capital gains, and return of capital, each taxed differently.
• Return of capital is not a bonus; it lowers your cost basis and affects the tax when you sell.
• Tax rules change, so confirm the current treatment with a qualified tax professional.

What is a REIT and how does it work?

Congress created REITs in 1960 so that ordinary investors could own a share of large real estate portfolios without buying property directly. To qualify, a company must meet requirements about what it owns, where its income comes from, and how many shareholders it has. In return for passing most of its taxable income to shareholders, it generally avoids paying corporate income tax on the portion it distributes.

The result is a company that behaves differently from a typical stock. It is built to distribute income rather than to retain it, so it often has less cash left for growth and relies on borrowing and new share issuance to buy more property. The SEC's Investor.gov publishes a plain-language bulletin on REITs that describes the structure and the main risks.

How do REITs earn their income?

There are two broad types. Equity REITs own and operate properties, such as apartment buildings, offices, warehouses, retail centers, healthcare facilities, and data centers, and earn rent. Mortgage REITs hold mortgages or mortgage securities and earn interest. Some hybrids do both.

The drivers differ. An equity REIT depends on occupancy, lease terms, and rent levels, so local supply and demand, tenant quality, and the length of leases all matter. A mortgage REIT depends on the gap between what it earns on its assets and what it pays to fund them, which makes it highly sensitive to interest rates and the cost of borrowing. Both types use debt, and both can be sensitive to rising rates, but for different reasons.

Why must a REIT pay out so much income?

To keep its tax status, a REIT must distribute at least 90 percent of its taxable income to shareholders each year. This is a legal requirement of the structure, not a promise about any particular payout or yield, and the distribution can be reduced if income falls.

A common mistake is to equate a high distribution rate with strength. A high rate can reflect a low share price, which may signal market concern, rather than generous earnings. A more useful check is how the distribution compares with the cash the company generates from operations after maintenance spending. REITs report a measure called funds from operations, which adds back depreciation, since real estate does not necessarily lose value the way accounting depreciation suggests. It is a useful measure, but it is not defined by the same rules as net income, so read how each company defines it.

How is REIT income taxed?

This is where many investors are surprised. Because the REIT avoids corporate tax on what it distributes, the tax is generally collected from you, and distributions are not treated the same as dividends from an ordinary company. Your Form 1099-DIV breaks a distribution into parts:

• Ordinary income, which is generally taxed at your regular rates
• Capital gain distributions, which come from property sales and are generally taxed at capital gain rates
• Return of capital, which is not taxed when received but reduces your cost basis

Most of a typical equity REIT's distribution is ordinary income, which is why the effective tax cost can feel higher than on qualified dividends from other companies. Some REIT dividends may qualify for a deduction under a provision of the tax code that has been subject to change, so check the current rules. The IRS publishes guidance on investment income, and a qualified tax professional can apply it to your circumstances.

What does return of capital mean?

Return of capital is the part of a distribution that exceeds the REIT's taxable earnings, often because depreciation lowers taxable income below the cash it generates. You do not owe tax on it immediately, but it is not a bonus. It reduces your cost basis in the shares.

A lower basis means a larger taxable gain, or a smaller loss, when you eventually sell. If basis reaches zero, further return of capital is generally taxed as capital gain. In effect, the tax is deferred, not removed. Keeping a simple record of your purchases and the return of capital shown on each annual tax form makes that future calculation easier, and many brokers track it for you.

Where you hold the REIT also matters. Held in a tax-advantaged retirement account, the character of the distributions may matter much less than in a taxable account, though account rules differ. This is a good topic to raise with the professional who prepares your return.

An illustrative quarter with a REIT holding

This walk-through is illustrative only and describes a hypothetical routine, not a result. Imagine a physician who owns shares of an equity REIT in a taxable account.

In the first month of the quarter, she opens the company's latest report and writes down its main property type, its occupancy, and when its large leases expire. In the second month, she compares the distribution declared with the cash from operations the company reported. In the third month, after the distribution is paid, she notes the amount in a simple spreadsheet and sets aside a line for the tax form that will arrive after year-end.

When the form arrives, she can match the three boxes to what she has recorded, and she sends the figures to her tax preparer without having to reconstruct them. Nothing about this predicts how the shares will perform. It simply gives her a record she understands.

Frequently Asked Questions

How do REITs make money for shareholders?

Equity REITs earn rent from properties, and mortgage REITs earn interest on real estate loans; most of the taxable income is then distributed to shareholders. Share prices can also change, so total results include price movement as well as distributions.

Are REIT dividends taxed differently from other dividends?

Often yes. Many REIT distributions are taxed as ordinary income rather than at the lower qualified dividend rate, and part may be return of capital or capital gains. Rules can change, so confirm the current treatment with a qualified tax professional.

What is the 90 percent rule for REITs?

To keep its tax status, a REIT must distribute at least 90 percent of its taxable income to shareholders annually. It is a requirement of the structure, not a guarantee that any given payout will continue.

Do REITs go down when interest rates rise?

They often come under pressure, because higher rates raise borrowing costs and make other income investments more competitive. The effect varies by property type, lease structure, and debt, so it is not uniform or certain.

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