How to Navigate Taxation on Your REIT Investment Returns Effectively

Investing in Real Estate Investment Returns Trusts (REITs) has become a popular way to enjoy the benefits of real estate ownership without having to deal with tenants, maintenance issues, or property management. But while REITs offer attractive dividends and portfolio diversification, the tax side of things can get a bit tricky. Understanding how REITs are taxed can help you keep more of your returns and avoid any unpleasant surprises come tax season.

In this guide, we’ll break down REIT taxation in plain English—so you can make smart investment decisions and optimize your tax strategy.

What Is a REIT? Quick Refresher

A REIT is a company that owns, operates, or finances income-producing real estate. They might own apartments, shopping centers, office buildings, hotels, or even data centers. Investors can buy shares of REITs through stock exchanges, just like other publicly traded companies.

The main draw? REITs are required by law to pay out at least 90% of their taxable income to shareholders in the form of dividends. That’s great for income-seeking investors, but these dividends are taxed differently than dividends from regular stocks.

How Are REIT Dividends Taxed?

When you receive a dividend from a REIT, it can be broken down into three main types for tax purposes:

Ordinary Income
Capital Gains
Return of Capital

1. Ordinary Income

Most of the dividend income from REITs is considered ordinary income, not qualified dividends. This means it is taxed at your regular income tax rate, which can be as high as 37% depending on your tax bracket.

So if you’re in the 24% tax bracket and receive $1,000 in REIT dividends that are classified as ordinary income, you could owe $240 in federal taxes on that amount.

However, there’s some good news…

Qualified Business Income (QBI) Deduction

Thanks to the 2017 Tax Cuts and Jobs Act, most REIT dividends classified as ordinary income qualify for a 20% QBI deduction. So instead of being taxed on the full amount, you’re only taxed on 80% of the income.

Let’s go back to that $1,000 example. After the 20% deduction, you’d only be taxed on $800, potentially saving you a couple hundred dollars depending on your tax rate.

2. Capital Gains

Sometimes, REITs distribute profits from selling properties. These are passed along to you as capital gains, and they’re taxed differently depending on how long the REIT held the asset.

Short-term capital gains (held for less than a year) are taxed as ordinary income.
Long-term capital gains (held for over a year) are taxed at favorable rates: typically 0%, 15%, or 20% depending on your income level.

3. Return of Capital

Some of your REIT dividend might be considered a return of capital. This isn’t taxed when you receive it. Instead, it reduces your cost basis in the REIT shares. When you eventually sell the shares, you’ll pay capital gains tax on the increased profit due to that lower basis.

This portion is essentially a way for the REIT to give you your own money back. It’s not taxable right away, but it will impact taxes later when you sell your shares.

How Do You Know What’s What?

Each year, REITs issue a Form 1099-DIV to shareholders. This form shows how your dividends were split between:

Ordinary income
Capital gains
Return of capital

It’s crucial to save this form and give it to your tax preparer or upload it into your tax software. If you misreport REIT dividends, you could either pay more than necessary or face IRS penalties.

How to Reduce Your Tax Burden on REIT Investments

While you can’t avoid taxes altogether, there are several smart ways to minimize how much tax you owe on your REIT dividends.

1. Hold REITs in a Tax-Advantaged Account

One of the best ways to handle REIT taxation is to hold REIT investments inside a retirement account like:

Traditional IRA
Roth IRA
401(k)

In a Traditional IRA or 401(k), you defer taxes until you withdraw the money, possibly at a lower tax rate in retirement. In a Roth IRA, you pay taxes up front, but withdrawals (including gains) are tax-free.

This strategy shelters your REIT dividends from current taxation entirely.

2. Be Strategic with Taxable Accounts

If you do keep REITs in a taxable brokerage account, pay close attention to the QBI deduction. It’s often underutilized. Also, consider timing your REIT purchases—buying near the ex-dividend date may result in receiving a dividend that comes with a higher tax liability.

3. Offset Gains with Losses

If you sell a REIT at a profit, you’ll owe capital gains tax. But if you’ve sold another investment at a loss, you can use that loss to offset your gain. This is called tax-loss harvesting, and it can help reduce what you owe at tax time.

4. Use a Professional or Tax Software

REIT taxation isn’t insanely complicated, but it does involve multiple layers. A good CPA or even high-quality tax software can help you categorize everything correctly, especially when dealing with return of capital or multiple REIT holdings.

Don’t Forget State Taxes

On top of federal taxes, you may also owe state income tax on your REIT dividends. Some states mirror the federal classification, while others have their own rules. If you live in a high-tax state like California or New York, this could significantly impact your overall return.

Final Thoughts: Plan Ahead and Keep More of Your Earnings

REITs are a powerful tool for generating income and diversifying your investment portfolio. But to make the most of your REIT investments, it’s crucial to understand how taxes will affect your returns.

To recap:

Most REIT dividends are taxed as ordinary income (but with a 20% QBI deduction).
Some portions may be capital gains or return of capital.
Holding REITs in tax-advantaged accounts is one of the easiest ways to reduce taxes.
Use tools like Form 1099-DIV, loss harvesting, and professional help to stay on top of your tax strategy