Taxes 101

Investment returns can be taxed in one of two ways. The first is capital gains, which is when an investment’s price increases between the purchase and sell date. If an investor bought a stock for $20 and sold it for $25, they will owe $5 in capital gains taxes. If they hold the asset for less than a year before selling it, they will pay short-term capital gains, meaning the gains will be added to their taxable income and overall federal income taxes. If they held the investment for a year or longer, they will instead pay a long-term capital gains tax where their return is taxed based on specific income-driven brackets that are generally lower than their federal income tax brackets.  

Investment returns can also be taxed if an investment directly passes along income such as dividends for stocks and interest for bonds. In most instances, this income is added to someone’s taxable income and taxed based on their federal income tax brackets. One notable exception is qualified dividends

Unique REIT Tax Considerations

REITs operate with a unique structure that create some differences in how investors incur and pay taxes. That’s because REITs are required to pass along at least 90% of their taxable income to shareholder, which means that this distribution is the primary means through which an investor is taxed.  

Within this distribution, income can be classified into one of three categories that each have different tax implications: 

  • Capital Gains Profit: Any income that a REIT manager acquired from selling underlying commercial properties held in the fund’s portfolio. If the manager sold the property after a year, the investor who receives the income is taxed based on long-term capital gains tax brackets. This source of income may also be subject to the 3.8% Net Investment Income Tax. 
  • Operating Profit: Any income earned through underlying commercial properties such as rent. Investors will generally pay ordinary income taxes on this source of income and may be subject to the 3.8% Net Investment Income Tax. 
  • Return of Capital: Any income that may be deemed nontaxable. This situation is most common when REIT managers deduct depreciation-related expenses from the REIT’s underlying real estate holdings. In this scenario, they can reclassify operating profit as return of capital up to the amount of the depreciation-related expense. 

REIT Tax Benefits

In addition to its unique structure, REITs also have some unique tax benefits that can serve investors. The first is the 20% Qualified Business Income Deduction, which may allow REIT managers to deduct up to 20% of operating profit income from their taxes. Investors will receive this tax benefit regardless of their taxable income, which makes this deduction incredibly compelling.

Second, REITs avoid double taxation. For many investments like stocks, businesses must pay a corporate income tax on the company’s yearly taxable income. These taxes directly reduce how much money that a company can either reinvest in the business or distribute to investors. REIT managers do not have to pay corporate income taxes, which increases the pool of money that managers pass to investors via distributions.

*Please consult a tax professional about your personal portfolio and tax needs.*

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Future articles in this series will dive into the various ways that our logistics REIT can add value.