How are REITs taxed?

A qualified dividend gets its preferential rate because the company already paid corporate tax on the profits behind it. The lower rate exists to soften double taxation.

A REIT does not pay corporate tax on income it distributes, provided it distributes at least 90% of taxable income. There is no double taxation to soften, so the distribution is taxed as ordinary income in your hands.

That means a REIT dividend can be taxed at 22% to 37% federally where an equivalent qualified dividend would face 15%.

Ordinary income is usually the largest piece, taxed at your marginal rate.

Return of capital is not taxed when received. It reduces your cost basis instead, which increases the gain when you eventually sell. It is a deferral, not an exemption, and it arises because depreciation reduces the REIT's taxable income below its cash flow.

Capital gain distributions arise when the REIT sells a property at a profit, and are taxed at long-term rates.

Your 1099-DIV shows the split, and it is usually finalised late, which is a common reason for a corrected form in February or March.

Ordinary REIT dividends generally qualify for a deduction of up to 20% of that income, which softens the disadvantage considerably.

At a 24% marginal rate, the deduction brings the effective rate on that portion to roughly 19%, closer to the 15% qualified rate than the headline comparison suggests.

Tax software applies it automatically. It is worth knowing it exists, because comparisons of REIT versus stock dividend taxation that ignore it overstate the gap.

If you receive $1,000 of distributions and $300 is classified as return of capital, you are taxed on $700 now and your basis falls by $300.

That $300 resurfaces as a larger capital gain when you sell, taxed at long-term rates if you held long enough. So the effect is to convert some ordinary income today into a long-term gain later, which is genuinely favourable.

The catch is record keeping. Basis reductions accumulate over years, and a REIT held for a decade can have a basis far below what you paid. Selling without accounting for that understates the gain and invites a correction.

Because the income is taxed annually at ordinary rates, a REIT held in a taxable account gives up a slice of its yield to tax every single year.

Held inside a 401(k), IRA or HSA, none of that applies. The distributions compound untouched, and the ordinary-income disadvantage disappears entirely.

This is the textbook example of asset location: the same holding, in a different account, with a materially different after-tax return and no change to the investment itself.

Mortgage REITs, which hold loans rather than property, distribute income that is almost entirely ordinary and often at a high yield, making the account placement question sharper still.

Non-traded REITs carry their own complications, including illiquidity and distributions that may include a large return of capital component funded from new investor money rather than operations.

Foreign real estate funds can involve withholding and, where structured as partnerships, a K-1 rather than a 1099.

The distribution yield, since a high yield means more income taxed annually.

The historical split between ordinary income, return of capital and capital gain, which most REITs publish.

Whether you have room in a tax-advantaged account for it instead, which is usually the better answer if you do.

Distribution classification, holding periods and 1099 reporting are in IRS Publication 550. Capital gains rates and holding periods are in IRS Topic 409. Walnut is informational and is not an investment adviser. This guide is educational and not personalized tax or investment advice; anything with a tax consequence is worth confirming with a tax professional.