It’s tax season again, and nobody enjoys handing over their hard-earned money to the government. However, there are ways to minimize the tax burden on investment income, particularly through real estate investment trusts (REITs). Let’s explore how REIT dividends are taxed compared to standard C-Corporations.
REIT dividends come in three main classifications: non-qualified dividends, capital gains dividends, and return of capital dividends. While it may seem like REITs are taxed at a higher rate than C-Corps, it’s important to remember that C-Corps are subject to double taxation. This means that the company pays corporate taxes on its income, and then investors pay taxes on their dividends as well.
For example, if a C-Corp has $100 of net income, it would pay $21 in corporate taxes and the remaining amount would be distributed to shareholders as dividends. If the investor is in the top tax bracket, they would pay 20% in taxes on the dividend, leaving them with $63.2 of after-tax income. In contrast, a REIT is a pass-through entity and does not pay corporate income tax. This allows it to distribute all $100 of its income to shareholders as dividends.
While REIT dividends are taxed differently based on classification, they generally result in lower overall taxes paid compared to C-Corps. This tax efficiency is one reason why REITs tend to have higher dividend yields. However, it’s important to note that individual companies may find ways to minimize their taxes, and the tax burden on REIT investors can vary depending on how dividends are classified.
To illustrate the tax implications of different dividend types, let’s compare REITs and non-REIT investments with a $100,000 investment and a 6% annual pre-tax yield for investors in the highest tax bracket. Corporate bonds are taxed as ordinary income at a 37% rate, while qualified stock dividends are subject to double taxation. REIT dividends, on the other hand, can be taxed anywhere from 29.6% to 0% through indefinite deferral.
For example, Realty Income Corporation (O) tends to classify its dividends as ordinary income, resulting in an effective federal tax rate of 27.59%. In contrast, Gladstone Commercial Corporation (GOOD) classifies a majority of its dividends as return of capital, leading to an effective tax rate of 1.60%. Return of capital dividends allow investors to defer taxation by reducing their cost basis in the stock, ultimately resulting in lower taxes paid.
Overall, return of capital dividends are considered the most tax-friendly treatment of REIT dividends, providing investors with a way to minimize their tax burden on investment income.
Source link
