What is a REIT and How Are Dividends Received from a REIT Taxed?

This year, we started a financial education series geared towards educating beginning investors and more specifically, beginning dividend growth investors.  Our first two articles explain what a dividend is and the dividend payout ratio (and how to calculate it). In this article, we will take a deeper dive into one specific type of holding that can be found in many dividend investors’ portfolio.  This holding typically pays a higher dividend, which is why dividend investors are always on the lookout for a great one. If you’re looking into becoming a dividend growth investor, you better get used to reading these four letters…REIT. Here is a deeper dive into what a REIT is and how dividends received from a REIT is taxed.

What is a REIT?

Let’s start with the basics.  REIT it stands for Real Estate Investment Trust.   Per Investopedia, a REIT “is a company that owns, operates or finances income-producing real estate.”   While a REIT may trade on a major index and pay a dividend like any other corporation, their corporate structures and the rules governing them are much, much different than a corporation.

The IRS has published strict guidelines that a REIT must comply with.  I’m not going to list out every single rule or guideline, but here were some of the major guidelines:

  • 75% of total assets must be considered real estate (or cash and treasuries)
  • 75% of the income must come from real estate.
  • Pay at least 90% of their taxable income in the form of dividends each year
  • Have a diversified group of shareholders.  A REIT must have 100 shareholders and no 5 shareholders can own more than 50% of a entity’s stock.

Types of REITs

Now that we understand what a REIT is and some of the rules and regulations that each REIT must achieve, we wanted to explain the two types of REITS.  Equity REITs and Mortgage REITS

Equity REITS

An equity REIT owns real estate and can take many shapes. Each Equity REIT may invest in a different type of real estate or industry.  Here are some examples of sectors and companies that operate in this sector.

  • Commercial Real Estate – Realty Income (O) –  One of the largest owners and operators of commercial real estate properties.  Some of Realty Income’s tenants include Walgreens, Fedex, Dollar General, AMC, Walmart, and other companies.  We both own shares in this company and love the monthly dividend.
  • Healthcare –  There are different types of Healthcare REITS.  So providing one specific example is difficult. Some own skilled nursing facilities (HCR Manorcare), assisted living facilities (Omega Healthcare), senior living facilities (Senior Housing Property Trust), medical offices (Healthcare Trust of America) or a combination of different facilities (Ventas and HCP).  Of course, there are other healthcare sectors that are not listed since the industry can be very specialized!
  • Public Storage and Self Storage –  Public Storage (PSA) – PSA is one of the largest REITs that owns and operates the self-storage facilities found throughout the country.  
  • Cell Towers – American Tower Corp (AMT) – AMT is a company that owns over 170,000 cell phone tower in North America, Europe, Asia, and the Middle East.  The company will lease the space on its towers to wireless companies to earn rental income accordingly.
  • Shopping Malls – Simon Properties (SPG) –  SPG is one of the country’s largest shopping mall owners and operators.  For this sector, think your traditional shopping mall with anchor tenants and other rent-paying shops
  • Digital Storage/Data Centers –  This is one of the coolest REIT sectors if you ask me.  This includes companies like Digital Realty Trust (DLR) and Equinix (EQIX).

Of course this list can go on and on. However, hopefully you can see that REITs operate in a ton of different industries and there are no two REITs that are alike.  That’s why it is important to read each REITs investor relations page and understand their holdings prior to investing in the company!

Mortgage REITs

A Mortgage REIT is much different than an Equity REIT.  Unlike an Equity REIT, which owns property and leases the property to different tenants, Mortgage REITs originate mortgage loans and mortgage-backed securities.  Rather than generating rental income, Mortgage REITs make money by generating interest income. Interestingly, Mortgage REITs are not limited to residential mortgages and residential mortgage-backed securities.  There are Mortgage REITs that originate residential mortgages (Such as Annaly Capital Management, NLY) and some that originate commercial properties (Blackstone Mortgage Trust, BXMT, or Apollo Commercial Real Estate Finance, ARI).  

Key Terminology – What the F-F-O?

When we screen for undervalued dividend growth stocks, one of the key components of our metrics is Earnings-Per-Share (EPS).  EPS is a GAAP metric that represents a company’s net income dividend by shares outstanding. GAAP stands for “Generally Accepted Accounting Principles,” the accounting framework by nearly all publicly traded companies.  There is some comfort in a company’s EPS figure, as this is an audited number within a company’s financial statements.

Even though a REIT is required to pay out 90% of its income, EPS is not the top metric used to evaluate a REIT.   The industry standard is a non-GAAP metric: Fund From Operations (FFO) or Adjusted Funds From Operations (AFFO).

FFO is a figure that begins with Net Income, and then adds back depreciation, amortization, and gains/losses on the sale of properties. The theory behind using FFO over EPS or other cash flow metrics is that it provides a better picture of a REITs true cash flows.  Depreciation, amortization, and gains/losses on sales are all non-cash items on an income statement.

Since FFO is a non-GAAP metric, it can be calculated differently for each company.  So please make sure you understand each company’s method for calculating FFO and AFFO to ensure you are making an apples to apples comparison.   

How Are the Dividends You Receive from a REIT Taxed?

Last, but definitely not least, the most important question for dividend growth investors.  Dividends received from traditional equity securities are subject to capital gains taxes. However, this is not the case for REITs, since REITs do not pay taxes at the corporate level

Dividends and distributions (or dividends received by shareholders) from a REIT are not a straightforward distribution. There are several components to each dividend and distribution.  Each REIT must provide investors with the following allocations for each dividend and distribution to ensure property tax treatment:

  • Dividends – Taxed as ordinary income, not a capital gain.  
  • Qualified Dividends – Taxed as a capital gain
  • Nontaxable Return on Capital –  Taxed as a capital gain

There was one huge change in taxation for REIT investors as well as a part of Tax Reform.   As a part of the bill, there is a 20% deduction on pass-through income.  Since a REIT passes through its income to shareholders, the individual holder will receive a huge benefit as a part of tax reform!

Prior to tax reform, since the majority of your dividend is taxed as ordinary income at a higher tax rate, I held all REITs in my Roth IRA so any future distributions are not taxed.    However, this 20% reduction is huge and would potentially impact future investment decisions (in terms of where I hold the investment.

Summary

REITs are great investments that can provide investors with a strong dividend yield.  REITs also provide investors a way to invest in the real estate markets without the stress of owning a property.  Hopefully you have found this guide to understanding a REIT helpful. Now the fun begins and hopefully you will begin performing research to determine if these companies fit your investment profile!  Also, if you think we missed any interesting types of REITs or want to also share some knowledge from your experience investing in these securities, please do so in the comment section!

-The Dividend Diplomats

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17 thoughts on “What is a REIT and How Are Dividends Received from a REIT Taxed?

  1. Great overview of REITs, and this is an area that I will be focusing on in the near future when I finally complete the rollover of an old pension to an IRA. The nuance you point out about how FFO can be calculated differently is really important to understand.

    If I am not mistaken, the tax changes this year have lessened the impact of having a REIT in a taxable account, however my approach is to still keep them in a tax-advantaged account.

    Thanks for the educational series; these articles are great!

    • DivvyDad,

      Thanks for stopping by and the kind words about our financial education series! You’re right, lower tax rates will help ease the tax burden for REIT dividends/distributions. It all depends on your income bracket and what your ordinary income tax rate, so each person will have a difference answer here. I hope I didn’t make it sound like using FFO is wrong, because that’s definitely not the case and each company typically reports it and shows a reconciliation. It was just important to point out that it is a non-GAAP metric and it is not an audited number. So just make sure you really understand what is included in the reconciliation and the number.

      Take care and thanks again.

      Bert

      • You definitely did not make it sound wrong to use the FFO, as that is definitely the right approach for REITs; however, I hadn’t fully appreciated that aspect of how it isn’t necessarily apples to apples for each company given that it is a non-GAAP number. It was a good point for me to recognize as I continue evaluating the REITs I will be looking to buy.

  2. I learn something new every day. I’ve always heard of REITs and of course I invest in Realty Income. But, I never really realized that there were only two types of REITs. Thanks for the information, and I agree with the above comment that this was a great post.

  3. What is some of your favorite home rental REITs for dividends basically rental properties without actually buying the relastate.

  4. Great simple explanation of REITs. REITs are relatively new holdings in my portfolio because of the simple fact that I did not fully understand their structures. I still have questions every now and then but for the most part I think I understand how they function. For now I hold only health REITs in my IRA account with no plans to add any new names for now. It’s all a learning process. Thanks for this info.

    • Thank you very much Keith! Understandable approach to investing in REITs and we definitely do not condone investing in a company that you don’t fully understand their functionality/how they make money. That’s the fun part about learning I guess, right?

      Bert

  5. Nice one gents! We also own a few Canadian REIT’s in our portfolio, the automatic reinvestment every month is fantastic, it’s just hard to find REIT that actually have a growing dividend, most stay relatively flat over the years.

  6. Well written and informative. I tend to avoid mortgage REITs having been burned by a couple during the financial crisis (does anyone remember that anymore?) I hold equity REITs in our IRAs to avoid ordinary income tax rates on the dividends. Tom

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