The landlord-free way to invest in real estate

Real estate has always had a place in wealth-building conversations, but most clients don't want the 2 a.m. plumbing calls that come with owning rental property. That's where real estate investment trusts (REITs) come in and it's why they keep showing up in client portfolios. When they do, the tax questions land on your desk.

What is a REIT?

A REIT is a corporation, trust or association that elects special tax treatment under Subchapter M. It operates or finances income-producing real estate. Instead of buying a property outright, investors buy shares of the company, the same way they'd buy stock. In practical terms, a REIT is a vehicle designed to own real estate or real-estate-related assets and to distribute most of its taxable income to investors, while generally obtaining a dividends-paid deduction that can substantially reduce entity-level federal income tax. 

The properties behind a REIT can include apartment complexes, office buildings, shopping centers, warehouses, hotels, health care facilities and data centers. Rent flows in and the REIT passes most of it along to shareholders as dividends. That pass-along isn't optional. To qualify for REIT treatment under §856, a company must meet strict income, asset and ownership tests, and §857 generally requires it to distribute at least 90% of its taxable income to shareholders each year. The REIT then deducts those distributions, so income is generally taxed once at the shareholder level rather than twice.

Why income-focused clients like REITs

The 90% distribution requirement is the headline. Because REITs must pay out nearly all of their taxable income, they often deliver higher dividend yields than typical stocks. For retirees and other clients who want steady cash flow without tenants, maintenance or property managers, that's an appealing trade.

REITs also spread risk across many properties, markets and industries instead of tying a client's fortunes to a single rental house. And publicly traded REITs buy and sell through an ordinary brokerage account, offering liquidity direct ownership can't match.

The tax treatment

Here's the part clients rarely understand. REIT dividends generally don't qualify for the lower capital gains rates most stock dividends enjoy. Because REITs already deducted the distribution, the bulk of what shareholders receive is taxed as ordinary income.

The good news sits in Section 199A. Qualified REIT dividends are eligible for the 20% qualified business income (QBI) deduction, and unlike QBI from a trade or business, this piece isn't subject to the W-2 wage or taxable income limitations. Clients get it whether they itemize or not.

Year-end reporting is where preparers need to slow down. A single REIT distribution reported on Form 1099-DIV, Dividends and Distributions, can include several components, each with its own treatment:

• Ordinary dividends, taxed at ordinary rates, with §199A dividends broken out separately in Box 5
• Capital gain distributions, taxed at capital gains rates
• Non-dividend distributions, a return of capital, which is generally nontaxable but reduces the shareholder's basis under §301

That basis reduction matters. Once basis hits zero, additional return-of-capital distributions become taxable gain, so tracking it year over year protects clients from surprises down the road.

A few honest caveats

REITs aren't risk-free. Rising interest rates can raise borrowing costs and pull income investors toward other options. Occupancy rates, property values and the broader economy all move returns, and dividends can shrink or disappear when conditions sour. Clients should hear that before they buy it, not after.  Some REITs are not publicly traded, which means clients should be aware that REITs can take time to sell and may not provide a quick source of cash. 

Valuation of REITS that are not traded on the open market can also be difficult to obtain. Clients need to understand what type of REIT they have purchased and how it’s funded. REITs give clients real estate income, diversification and liquidity without the headaches of direct ownership. For tax professionals, knowing how the pieces fit, from the §857 distribution rules to the Box 5 breakout on Form 1099-DIV, turns a confusing year-end statement into a planning conversation your clients will thank you for.