Also known as REIT, a real estate investment trust is known as a mutual fund for real estate. From the name, one can infer that the trust invests in investments related to real estate. Interested investors purchase a share in the trust, and they realize income from the holdings.
Since the nature of cash flow from real estate investment differs, the income that investors get from REIT can be classified into various forms, all with their individual tax rules.
Understanding the type of REITs
There are two types of REITs which depend on the way they generate their funds,
An Equity REIT possesses investment properties, majorly real estate. People in this line of business make their money from rent fees coming from tenants and transacting properties.
Mortgage REIT, on the other hand, is a lender. The mortgage provides a way of financing mortgages, which happens in two ways.
It could be via lending to people or
Purchasing mortgages from financial institutions like banks
People in this line of business make their money from funds collected on the mortgage.
We can classify some REITs as hybrid because they are involved in both activities. Generally, REITs are not subjected to taxes, provided they give out 90% of the revenue to shareholders.
Tax Treatment is a Factor of Payment Type
REIT payments are classified as dividends. This dividend, however, is not the same as the one you get when you buy stocks. Besides, REITs generate funds in various ways.
Dividends come in three forms:
Capital gains: Funds made from the sale of properties above the REIT you got for it.
Ordinary Income: Funds from rent payment or mortgage collection
Capital Return: We can classify this as getting a share of your money from REIT
Generally, the accepted rule is that the events in REIT determine the tax nature.
Keeping REITs in Retirement Account Plans
For people interested in REIT, which is a part of the tax-advantages RSA plan like a 401(k), none of the tax treatment matters. The reason is that investment returns for such plans are not taxed when earned.
People with 401k and traditional IRAs will pay income taxes on withdrawing money from the account. However, you will not have to pay taxes on Roth IRA or Roth 401(k). In taking money from any of these IRAs, they are considered as ordinary income, not minding whether it is a dividend, or capital gains.
There are instructions on Form 1099-DIV that guide you on reporting every form of payment that will go on your tax return.
Ordinary Income Distributions
REITs have dividends that we can classify as ordinary income. On Form 1099-DIV, Box 1 comes in two sections:
Box 1a reveals the total dividends or "ordinary dividends." The tax rate for this will be the normal income tax rate
Box 1b reveals "qualified dividends." You will see the qualified dividends in the value displayed in Box 1a, which is not added to what you have in Box 1a. The portion of the qualified dividends will be taxed at a reduced capital gains rate.
Dividends that you get from REITs will be exempted automatically from qualified dividends. However, the qualification of dividends is a factor of the type of investment that produced the funds that shareholders get.
Distributions from Capital Gains
The tax on capital gains will either be long term gains or short term gains. This depends on the time you acquired the investment.
On the other hand, individual investors report distributions from capital gains REITs as long-term gains. It does not matter the duration of the money.
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