How are REITs taxed compared to direct real estate ownership?

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The biggest difference is who gets the tax attributes. With direct real estate ownership, particularly through an LLC or partnership, income, deductions, depreciation, gains and losses often pass through to the owner. That means the investor may be able to use depreciation deductions from the property on their own tax return, subject to passive activity, basis and at-risk rules.

With REIT ownership, the investor generally owns shares, not the underlying property. The REIT itself owns or finances the real estate, calculates its income and deductions, and typically must distribute at least 90% of taxable income to maintain REIT status. The investor then receives tax reporting on Form 1099-DIV, not a Schedule K-1. That makes reporting simpler, but it also means depreciation does not pass through to the shareholder in the same way it can with direct ownership.

From an investor’s perspective, REIT taxation usually shows up in three buckets: ordinary income, capital gain distributions and return of capital. The ordinary income portion is generally taxed at the investor’s ordinary income tax rate. Capital gain distributions may receive long-term capital gain treatment. Return of capital is generally not taxable when received; instead, it reduces the investor’s basis in the REIT shares, which may increase taxable gain when the shares are later sold.

This is why REIT dividends tax treatment can feel less straightforward than a normal stock dividend. Many common corporate dividends may qualify for lower qualified dividend rates. REIT dividends often do not, because REITs generally avoid entity-level corporate income tax by distributing income to shareholders. In effect, the tax is pushed out to the investor.

There can still be REIT tax benefits. Qualified REIT dividends may be eligible for a deduction of up to 20% under the Qualified Business Income rules, subject to the applicable limitations. The IRS instructions for Form 8995 state that eligible taxpayers may deduct up to 20% of qualified REIT dividends, along with certain other qualifying income.

Direct ownership may offer broader tax planning opportunities, especially where depreciation, cost segregation, debt financing, passive loss planning or eventual sale strategy are important. A direct owner may also have more control over timing: when to refinance, improve, exchange, sell or hold. By contrast, a REIT shareholder is largely along for the ride. The REIT’s management team makes the property-level decisions, and the investor receives the tax character reported after year-end.

The REIT tax treatment may be more convenient, but convenience is not the same thing as control. A REIT can provide liquidity, diversification and simplified reporting. Direct real estate can provide more hands-on tax planning, but also more complexity, concentration risk and administrative burden.

A Delaware Statutory Trust may sit somewhere between these concepts for certain investors, particularly those considering fractional real estate ownership or 1031 exchange planning. It is not the same as a REIT, and its tax treatment should be reviewed separately.

So, how are REITs taxed compared to direct ownership? REIT investors are generally taxed on distributions reported to them, while direct real estate owners may receive a fuller pass-through of property-level income and deductions. The better structure depends on the investor’s goals: simplicity and diversification, or control and deeper tax planning.

How BT Can Help

For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Rick Suid, Partner in Bennett Thrasher’s Financial Reporting & Assurance practice with extensive Real Estate industry experience, or call us at 770.396.2200.

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