Real estate investment trusts (REITs) are a type of company that invests entirely in real estate portfolios. They are exempt from having to pay income taxes on their own income, provide they channel at least 90 percent of profits to their shareholders in the form of dividends. These come from rent payments, and capital gain distributions, representing the shareholder's pro rata share of profitable sales of properties, less any losses in the REIT portfolio.
The U.S. tax code grants favorable treatment to dividend income from U.S.-based companies, under certain circumstances. The company must have been formed in the U.S., a U.S. possession, or be from a country that has negotiated this favorable treatment through a treaty agreement with the U.S. It can also market its shares on U.S. exchanges via American Depositary Receipts, or ADRs. As of 2011, dividends from qualified companies are taxed at 0 percent for those in the 10 to 15 percent marginal income tax brackets, and 15 percent for everyone else. This favorable arrangement expires at the end of 2012, at which point all dividend income is taxed according to ordinary income rates, unless Congress extends or alters the existing law.
Taxation of REITs
While the IRS does not require the REIT itself to pay income taxes, most income from REITs is taxable at ordinary income rates to the shareholder. REIT income, therefore, does not generally qualify for the same tax treatment afforded to qualified dividends.
Although most REIT income is taxable at ordinary income rates, this is frequently favorable to the tax treatment afforded to C corporations, which are subject to double taxation. Because C corporations cannot deduct dividend payments to shareholders, they must pay income taxes on their own profits at 35 percent before they can distribute income to shareholders. Most taxpayers have individual income tax rates below the 35 percent threshold, so they benefit from the pass-through tax treatment of REIT dividends.
Regardless of taxation, REITs can provide investors with an efficient diversified exposure to the real estate asset class, which frequently moves in a different direction than the stock market. Some exposure to REITs can help diversify an individual investment portfolio.