A while ago I wrote about the tax benefits of dividend income versus ordinary income you would earn as an employee. At the end of my piece, I briefly mentioned that if you own a REIT you’ll be taxed at ordinary income tax rates for most dividends you receive.
Today I hope to explain why REIT dividends are taxed at higher tax rates and why that can be a good thing or a bad thing depending on your situation.
Different kinds of dividends for tax purposes
To start off with, I want to cover some of the different kinds of dividends you can receive.
In my first piece on dividend taxation, I explained the difference between qualified dividends and ordinary dividends.
As a brief reminder, ordinary dividends are the dividends you receive that are not qualified to be taxed at the lower 0-20% tax rates that qualified dividends are taxed at. Qualified dividends are dividends that do qualify for lowered taxes.
Usually, you can determine exactly which of the dividends you received over the year are ordinary dividends by looking at box 1a on your 1099-DIV. Your qualified dividends are listed in box 1b, but are included in the total in box 1a, so don’t freak out that you’re going to get taxed twice. You’re not.
Just know that any difference between the two will be taxed at your ordinary income tax rate.
Taxation of corporate earnings
Now that we’ve covered the difference between ordinary and qualified dividends, we need to talk about the taxation of corporate income. The first thing I have to tell you is some bad news.
Remember how I said that dividends are taxed at lower tax rates than ordinary income?
I sort of lied.
When dividends are paid to you they’re taxed at lower rates, but the truth is that they’re being taxed for the second time. Let me explain.
The way the United States has structured their corporate income taxes is similar to the way the structure our individual income taxes, with a progressively higher tax rate based on income brackets. The corporate tax rate in the US ranges from 15% to as high as 39%.
One quirk about the US corporate tax is that the maximum effective rate is actually 35%. The higher tax rates in some income bands are designed to produce tax revenues that would have been the same as having a flat 35% income tax rate no matter what your income was.
Like individuals, corporations in the US are able to take certain deductions and exemptions that decrease their taxable income, which is then used to calculate their income taxes owed.
From that amount, they can then take other deductions and use tax credits to further decrease their income taxes. Frequently, they are even allowed to defer portions of their income taxes for the year into the future, which is a good thing if you’re aware of the time value of money (TVM).
Once all deductions, exemptions, and credits have been factored in, you arrive at the net income for the business, which can then be distributed to shareholders as dividends. The fact that those dividends are then taxed again when you and I received them is why I say that they suffer double taxation.
That second line of tax is one of the reasons some financial advisors and investment analysts are downright negative when it comes to the payment of dividends.
They argue that shareholders would be better served by reinvestment into the business, where they can produce additional gains for the shareholders without being reduced by tax.
I invite them to look at Enron.
Alright, just kidding.
Technically they’re correct, but there are several other factors that play into whether a shareholder should want a dividend. I feel that they tend to ignore those factors in favor of the answer that is most mathematically correct.
Life is, in my view, more complicated than the math implies.
REIT history & taxation
Since we’ve covered the way most companies are taxed in the United States, it’s time for us to discuss REITs, and how they’re taxed.
REIT, if you didn’t already know, stands for real estate investment trust. They were first created during the 1960’s and have gone through several iterations as the legislative environment has changed over the years.
The basic idea behind a REIT is to allow investors to invest in real estate without having to front huge amounts of money themselves. Instead, investors can buy shares in the REIT like they would any other publicly traded corporation.
To be classified as a REIT, a company has to have a minimum of 100 shareholders and derive at least 75% of its operating profits from real estate investment.
This structure greatly reduces the capital required to invest in real estate and allows investors like you and me to diversify our real estate portfolio instead of staking all our capital in one real estate property. Additionally, REITs are required to pay at least 90% of their profits out as a dividend to their shareholders, so you can be sure that a profitable REIT will pay you a dividend.
The big advantage to REITs, aside from capital outlay and diversification, is how they are taxed.
In exchange for meeting requirements to be considered a REIT, REITs can deduct the dividends they pay from their corporate taxes, leaving them with an extremely low tax rate.
Sometimes no tax rate.
Because REITs are largely exempt from income taxes, the dividends they pay out are ineligible for classification as qualified dividends. In exchange for exemption from corporate taxes, shareholders have to include their dividends as part of their ordinary income.
So, if you’re in the 25% tax bracket and receive $100 in dividends from a REIT, you’ll be required to pay $25 dollars in taxes on those dividends.
Sounds like a raw deal, right?
Advantages of a REIT
Well it might not be such a raw deal after all.
Let’s consider some of the advantages to REIT dividends and how they impact you as an investor.
First of all, if you’re like me and my wife, our income tax rate is 0% because we’re poor college students. I don’t care about my REIT dividends being taxed at my ordinary income tax rate because I don’t have one. (Please note: technically we’re in the 10% tax bracket, but our exemptions and deductions eliminate our taxable income.)
Better, the only taxes I pay on my income right now are FICA and Social Security, so I’m A-OK with skipping out on these because my dividend income isn’t derived from employment.
Depending on how many kids you have and your annual income from your job, you might also fall into a 0% tax bracket.
If so, invest in REITs without any fear of taxation. You’re getting a proportional share of 90% of the REITs profits without paying a dime to Uncle Sam. I’d take that deal any day of the week.
When it comes to REIT dividends, the only reason you should care about tax rates is if you fall into the 25% or greater tax brackets. For 2017 that means you need to be making more than $37,950 if you’re single, $75,900 if you’re married, and $50,800 if you file head of household.
If your income is lower than those amounts, your dividends will be taxed at the 10% or 15% rate and be comparable to the qualified dividend tax rates you’d get if you invested in something other than a REIT.
If you are in the 25% or higher tax brackets, see my list of disadvantages of REIT dividends below.
Another advantage to REIT investing
If you invest in a REIT you can be assured of a high dividend payment, provided that the REIT you invest in is profitable. A natural result of being required to pay out 90% of their profit as a dividend means that you can expect a higher dividend payment relative to other investment opportunities.
At the same time, you’ll notice I didn’t say you’d be getting a high dividend yield. For the best REITs, investors tend to drive up the share price, decreasing your yield. When that happens you’ll probably end up with a higher yield than normal, but it’s not a guarantee.
A final advantage to investing in a REIT is one that I already mentioned, but I’m going to bring up again.
Investing in a REIT means that you can invest in real estate without having to front a few thousand dollars as a down payment. You can also diversify your real estate portfolio very quickly since the REIT or REITs you’re invested in will have multiple properties in their portfolio at any given time. You’re also spared the trouble of learning the ins and outs of real estate by yourself since you can take advantage of the REITs staff and their expertise.
Disadvantages of a REIT
Since a discussion about REITs wouldn’t be complete without covering some of their disadvantages, let’s talk about those now.
First thing’s first: taxes.
If your household income is above the threshold I mentioned earlier, REITs are taxed higher than qualified dividend income.
An example of REIT vs qualified dividends
So let’s say that you received $1,000 of dividend income, you’re single, and your annual income is $55,000. If you had invested in a company that paid qualified dividends that extra $1,000 of income would be taxed at 15% and you would owe $150 in taxes on it. By receiving a qualified dividend you’ve reduced your effective tax rate from 17.25% to 17.21%.
On the other hand, let’s assume the same, but this time you invest in a REIT and receive $1,000 in dividends. Since they’d be taxed at 25% you’d owe $250 in taxes, and your effective tax rate would increase from 17.25% to 17.39%.
That might not seem too bad yet, but it only gets worse the higher your tax bracket and the higher your REIT dividends.
That said, you shouldn’t avoid investing just to avoid taxes, as I discuss in my piece on common tax misconceptions.
Another problem with REITs is management.
Yes, I know I said an advantage to investing in a REIT is that you can rely on management’s expertise. The bad thing about management is that they might be incompetent. Real estate is an investment vehicle which, unfortunately, allows fools to make a lot of money and look very wise when times are good, much like the stock market.
The problem is what happens when times are bad.
Real estate is more illiquid than other investments, so a poorly managed REIT will have a harder time turning things around relative to some of their publicly traded peers. Some REITs even manage to lose money when times are good because there’s always a bad deal that looks attractive floating around somewhere.
If you invest in a REIT you need to understand that management might, unintentionally, screw you. If you were to invest in real estate for yourself you’d have no one to blame for your mistakes but yourself.
I also think that a disadvantage to REITs as your primary investment vehicle into real estate is that you’re unlikely to learn the ins and outs of real estate on your own. In my view, the best time to invest in a REIT is after you already own a few pieces of property yourself.
I don’t think this disadvantage is a deal breaker, but I’m also not a fan of the investor who invests in REITs and never does anything else with real estate. Ignorance is not your friend.
Closing thoughts on REITs
As I’ve said, there are a few great reasons you should invest in a REIT. For me and my wife, those advantages outweigh the disadvantages some of the time, and we’re long on two REITs. But other than one specialized REIT I’m still evaluating we’re not planning on opening a new position in a REIT anytime soon.
That said, I think there are also several disadvantages to REITs, not the least of which is their tax implications to high-income earners. I’ve watched several REITs implode and cut their dividends since I started following the sector.
REITs aren’t something that I recommend to most of my family and friends because I know that they’re unlikely to be able to make a good investment decision or understand what they’ll do to their taxes.
Additionally, REITs have a big problem built into them.
They make it too easy to get greedy, and greed leads to poor investment decisions. Chasing high dividend yields can be a terrible idea, and REITs almost all have high dividend yields.
So should you invest in a REIT?
Maybe. If you’re willing to accept the risk and if you understand the tax implications. I hope this article helped you to understand them better, and if you have any questions you can always reach out to me and I’ll do my best to answer them for you.