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How a REIT distribution is taxed

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A cash payment is not always profit. Check its character, then keep income and liquidity separate.

The ruleOrdinary REIT dividends generally enter ordinary income. Returned capital reduces basis. A REIT distribution does not guarantee profit, repayment or a ready market for the shares.

Income, returned capital and access to your money

A REIT has to distribute at least 90 percent of its taxable income each year, so distributions are the point of owning one. What arrives is not a single kind of money. The Form 1099-DIV the investor receives splits it into components, and each component has its own tax answer.

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A distribution can include ordinary dividends. REIT ordinary dividends generally do not qualify for the reduced rates on qualified dividends. Use the character reported on Form 1099-DIV rather than treating every payment as the same kind of income.

Some payments return part of the investor’s own capital. A return of capital reduces the cost basis of the shares; it is not a new investment profit. In the simple example below, the payment is less than the starting basis.

Receiving distributions does not make a non-traded REIT liquid. Such shares have no ready exchange market, and repurchases may be limited or unavailable. Even listed shares can lose value. Income and the ability to recover the purchase price are separate questions.

In this below-basis example, every dollar of returned capital lowers basis by a dollar. That increases a later gain, or reduces a later loss, compared with using the original basis. The investor must use the adjusted basis; a future taxable gain is not guaranteed.

Exam terms (4)
Ordinary dividend
The main component, included in ordinary income, generally without the reduced rate.
Return of capital
Returns invested capital and reduces basis; not taxed on receipt in this below-basis example.
Adjusted cost basis
What the shares are treated as having cost, after any return of capital.
Form 1099-DIV
The form that tells the investor how the distribution was split.

Income or returned capital?

Ordinary dividendReturn of capital
Taxed when receivedGenerally yes, as ordinary incomeNo in this example; reduces basis
Reduced dividend rateGenerally not availableNot a dividend
Effect on cost basisNoneReduces it, dollar for dollar
On a later saleNo basis change from the dividendLower basis changes the reported gain or loss
Returned capital reduces basis; cash received is not automatically profit.

Try it: An investor buys REIT shares at $30 and over several years receives $12 a share classified as return of capital, then sells at $40. Work out the basis at the sale and the gain, and then work out what the gain would have been had none of the distribution been a return of capital.

Check yourself

Try a question, then read the explanation to review the rule.

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Worked example

An investor buys REIT shares at $30 a share, receives $12 a share of return of capital over several years, and sells at $40. Assume no other basis adjustments or selling costs.

  1. None of the $12 was taxed when it arrived, because a return of capital is not a dividend.
  2. It reduced the adjusted cost basis from $30 to $18 a share.
  3. The sale at $40 therefore produces a gain of $22 a share rather than the $10 the purchase price alone would suggest.
  4. That $22 is the $10 the shares actually rose plus the $12 that was never taxed on the way through.

Same rule, new context

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The closest contrast

Ordinary dividend: taxed now.

Return of capital: reduces basis in this example.

Check the tax character shown for each component. A return of capital below basis is not taxed on receipt, but it reduces the basis used to calculate a later gain or loss.

Summary

  • A distribution’s character matters; receiving cash does not by itself mean the investment earned a profit.
  • The ordinary component is taxed as ordinary income and generally does not get the reduced dividend rate.
  • In this below-basis example, returned capital is not taxed on receipt and reduces adjusted basis.
  • A non-traded REIT can distribute cash while its shares remain hard to sell.
  • Returned capital changes the basis used on a later sale; it does not establish permanently tax-free profit.

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