For income-focused investors, a distribution rate can be an important starting point, but it does not always tell the full story. What investors ultimately retain after taxes may depend on how an investment’s distributions are characterized, which is why after-tax distributions can be an important consideration when evaluating income-producing real estate investments.
Real estate investment trusts, or REITs, generate distributions and may offer portfolio diversification, regular cash flow, capital appreciation, and long-term wealth planning strategies. Investing in real estate through a REIT can also provide many of the potential benefits of direct property ownership without the responsibility of managing properties directly.
The Return of Capital Play
REIT distributions are taxed at different rates depending on how they are characterized. Due to real estate-related tax deductions such as depreciation and amortization, REITs are generally able to characterize a portion of distributions that would otherwise be ordinary income as return of capital, or ROC.
ROC distributions are generally tax deferred until redemption, at which time they may give rise to capital gains. As a result, two investments with the same stated distribution rate may produce different after-tax outcomes depending on how much of the distribution is taxable in the year received.
Why Return of Capital Matters for After-Tax Distributions
Unlike a stated distribution rate, after-tax distributions factor in taxes owed on investment income, offering a clearer view of what investors may keep. This can be especially meaningful when comparing REITs to fully taxable investments with the same stated distribution rate. For REITs, this distinction matters because distributions may include ROC, which can defer taxes by reducing an investor’s cost basis rather than being taxed as current income.
Consider the following hypothetical example: A $100,000 investment with a 5.00% annual distribution rate and various levels of ROC, compared with a fully taxable investment generating the same gross distribution.[1] As the ROC portion of the REIT distribution increases, more of the distribution may be tax deferred, potentially improving what the investor keeps after taxes.
NOTE: Investors may also be subject to net investment income taxes of 3.8% and/or state income tax in their state of residence, which would lower the after-tax distribution rate received by the investor. These taxes are not shown in the hypothetical example above.
* Assumes an ordinary federal income tax rate of 37%, no 20% tax rate deduction, and no classification as ROC.
** Tax-equivalent distribution rate assumes that the investment in REIT shares is not sold or redeemed and reflects the pre-tax distribution rate an investor would need to receive from a theoretical investment to match the stated after-tax distribution rate earned by a REIT stockholder if the distributions from the theoretical investment (i) were classified as ordinary income subject to tax at the top marginal tax rate of 37%, (ii) did not benefit from the 20% tax rate deduction, and (iii) were not classified as ROC. The ordinary income tax rate could change in the future.
For a closer look at the figures behind this comparison, check out Inland's REIT Investments Offer Compelling After-Tax Distributions
Additional REIT Considerations
Beyond distribution tax treatment, REITs may offer additional considerations for certain investors, including efficient tax reporting through IRS Form 1099-DIV rather than a K-1, potential use as an effective unrelated business taxable income blocker for qualifying tax-exempt investors, and estate planning considerations such as a potential step-up in basis when shares are inherited.
REITs may also engage in 1031 exchanges to defer recognition of taxable capital gains at the entity level. For investors evaluating REITs as part of a long-term wealth planning strategy, these tax-related characteristics should be reviewed alongside the investment’s risks, objectives, suitability standards and offering materials.
Takeaway
Understanding the tax characterization of REIT distributions is particularly important for investors seeking attractive long-term income and wealth planning strategies. While a stated distribution rate can be useful, after-tax distributions and tax-equivalent yield may provide a clearer view of how a REIT investment compares with a fully taxable income investment. Investors should consult their own tax, legal, accounting, financial or other professionals before making an investment decision.
IMPORTANT INFORMATION: This blog describes the tax considerations for U.S. Individual Investors only. Non-U.S. investors are subject to additional tax considerations not discussed herein.
[1] The hypothetical example and any accompanying communications have been prepared for informational purposes only, and are not intended, and should not be construed, as tax, accounting or legal advice to any potential investor. All prospective investors are strongly encouraged to consult with and rely on their legal, accounting, financial or other professionals. This model contains several assumptions about future events of a hypothetical real estate investment trust. These assumptions are arbitrary and do not correspond to any specific real estate investment trust.