Investors seek out Real Estate Investment Trusts (REITs) for stable, predictable cash flows. Many REITs have strong dividend yields which make them attractive. Dividend payments made by a REIT are taxed to the investor as ordinary income, unless they are considered to be “qualified dividends”. Qualified dividends are taxed at the more favorable capital gains tax rates versus nonqualified dividends which are taxed at the investor’s top marginal tax rate.
A portion of dividends paid by REITs may be classified a nontaxable return of capital. This is usually determined at the end of the year when the REIT is closing their books. These payments reduce an investor’s cost basis in the REIT investment. This creates a potential tax trap for unwary investors and unknowledgeable tax preparers.
Reporting the sale of a REIT investment is similar to reporting the sale of a common stock, but there is one key difference. When selling a common stock, you take the gross proceeds of the sale and subtract the cost basis to determine the capital gain or loss. Cost basis is what the investor paid for the security, plus related costs and commissions. This information is easily found on the investor’s trade confirmation or brokerage statements.
Determining the cost basis on a REIT has subtle difference. Remember those nontaxable returns of capital mentioned earlier. A nontaxable return of capital is return of the initial investment and these reduce the cost basis in the REIT. To determine the actual cost basis in the REIT one would need to look back at all of the 1099s received from REIT to determine how much return of capital was actually received.
Don’t count on your broker to do this and I certainly would not rely on the gain/loss statements issued by the brokerage. I can almost guarantee they are not tracking this on your behalf. A clever tax professional might be tracking your REITs cost basis, but it is likely most tax preparers are not. I wonder how many REIT investors have understated their capital gains to the IRS.
Another tax trap of REITs is one that I promise you most tax professionals are not even aware of. This tax trap affects every REIT investor who is participating in the REIT’s dividend reinvestment plan (DRIP). Most all REIT DRIPs allow shareholders to reinvest their dividends and purchase additional shares in the REIT at a discount.
The discounts can range between 0 and 5 percent of the market price of the shares. The tax trap is the discount represents a taxable dividend to the REIT owner and it is not reported on 1099 issued by REIT. Herein lays the tax trap. How many REIT investors have underreported their dividend income because of the discounts they received from the DRIP? I suspect almost all of them. How many tax professionals are aware of this? I suspect almost none of them.
REITs are not required to report these discounts on 1099s because only amounts paid to investors or reinvested into the DRIP are required to be reported per IRS guidelines. This is why you will see on REIT DRIP statements “SAVE THIS STATEMENT FOR TAX PURPOSES”. I wonder how many investors look at the year-end statement, compare the gross amount reinvested to their 1099 and then toss the statement after they can reconcile to the gross amounts reported on the 1099. This is a big mistake. Every REIT investor participating in a DRIP should be retaining their December 31st statements which show all of the year’s transactions. These statements reflect the shares purchased and the fair market value of the shares. The difference is the discount and it’s TAXABLE.
Most REITs don’t give investors any guidance related to the taxability of the discounts on the DRIP statements other than the standard “Consult Your Tax Adviser”. If a tax professional isn’t aware of this tax trap, what good would he or she be in consulting on an investor on this topic? It’s not that a REIT is trying to deceive their investors, but they are not allowed to provide tax advice. I will tell you this issue on the taxability of the discounts is covered clearly in REIT literature…if anyone has taken the time to read it.
Other than the current taxability of the REIT discounts, there is another tax issue. The discounts (since they are considered taxable income) are also added to the cost basis of the shares held in DRIP. I’m equally positive that anyone who has failed to report the discount as taxable income is more likely than not to be oblivious to the impact on cost basis. I wonder how many investors overstated their capital gains when reporting the sales of the REIT DRIP shares. My guess…almost all of them!
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