Real Estate Investment Trusts (REITs) have lost some of the luster lately. Fear of larger tax bills and rising interest rates, have discouraged many investors from adding REITs to their personal financial plans. New research from the National Association of Real Estate Investment Trusts (Nareit) and published in the Wall Street Journal (April 19, 2005, Eastern edition) indicates the tax burden may be lower than previously thought.
By law, REITs have to pass a large portion of the income they generate directly to investors. This allows distributions from REITs to bypass corporate taxes like the 15 percent dividend-tax rate enacted in 2003. Distributions from REITs are taxed at ordinary income tax rates which can be as high as 35 percent. Nareit research however, indicates that 37 percent of distributions from REITs in 2004 were taxed at lower rates.
More than half of the 37 percent was taxable as capital gains. Capital gains are commonly taxed at a 15 percent level, but the tax burden can be as low as 10 percent for some investors. The remaining portion of the 37 percent were nontaxable distributions such as return of capital, the capital gains on which are typically taxed at the 15 percent rate if the shares were held for more than a year.
This is possible because REIT distributions are paid from a variety of sources not just the income the REIT generates. Some of the distributions are paid out in the form of “qualified” dividends, some are from capital gains, and some are return of capital. Each source has its own tax implications because the source of the distribution determines the tax rate.
Unfortunately, it is difficult to predict what source a REIT distribution will come from. Nareit research indicates the portion of distributions coming from sources taxable at lower rates has been on the increase since 1998. Additionally, the research shows that the percentage of REIT distributions taxed beneath the 35 percent income tax level has varied between 17 percent and 37 percent since 1995.