Real estate investment trusts (REITS) are corporate entities investing in real estate, mortgages or a hybrid of the two. Many REITS are traded on public stock exchanges like equity securities, although REITS may be privately held as well. In the United States, the income from REITS is taxed to individual shareholders when distributed annually and when the REIT is sold.
REIT Corporate Taxation
Before income from REITs is taxed to the shareholders, REITs must meet certain requirements under section 856 of the U.S. Internal Revenue Code. Of these requirements, the most significant is that at least 90 percent of the REIT's taxable income must be distributed to the REIT's shareholders in the form of dividends. Even when this 90 percent requirement is met, any taxable income of the REIT that is not distributed to shareholders is taxable to the REIT at corporate income tax rates.
When REITs distribute annual earnings to taxpayers, these earnings are taxable to the shareholders as dividend investment income. For individual income tax payers, dividend income is taxable at full, ordinary income levels, except when classified as "qualified dividends." While the IRS has a number of requirements for REIT distributions to be taxed as qualified dividends, this requirement is generally met by shareholders who have owned the REIT for a minimum of 60 days before or after the dividend was declared. When REIT dividends are considered qualified, they are taxed at long-term capital gain rates, which are significantly less than ordinary income tax rates.
The final portion of REIT taxation occurs when the REIT shareholder sells his interest in the REIT. The Internal Revenue Service (IRS) treats the sale of interests in a REIT in the same manner as the sale of other capital assets, such as stocks and bonds. Shareholders are taxed on the capital appreciation or depreciation of the REIT's shares. When the value of the REIT's shares have increased, the shareholder has a capital gain. When the value of the REIT's shares have declined, the shareholder has a capital loss. Investors who have held the REIT's shares for more than one year are eligible for taxation at reduced long-term capital gain rates.
Limitations on Capital Losses
While there are no limitations to the amount of capital appreciation a shareholder may claim on an individual income tax return, a taxpayer may only claim a capital loss up to $3,000 annually. Taxpayers may first offset any capital loss from the sale of REIT shares against all other sources of capital gains income. After this offset, the first $3,000 of loss may be offset against all other forms of the taxpayer's income. Any loss that the taxpayer cannot claim during the current tax year may be carried over to the subsequent tax year.
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