REITs such as W.P. Carey Inc. (WPC), Liberty Property Trust (LRY) and others offer many advantages, such as a steady income stream, which I won't rehash here. I'm more concerned with the tax treatment of REIT distributions, which tends to confuse investors. I'll explain the tax treatment of the distributions and then discuss the implications for your portfolio.
The Taxation of REIT Distributions
REITs invest in real estate (and mortgages, in some instances) and make distributions to unit holders. A unit holder faces a slate of three possible tax treatments on these distributions: (1) ordinary income, (2) long-term capital gains, and (3) return of capital ("ROC"). Each distribution is not necessarily taxed in its entirety as either ordinary income, or long-term capital gains, or ROC; rather, a single distribution may consist partly of return of capital, partly of ordinary income, and partly of capital gains.
What determines the breakdown of each distribution? Put simply, the REIT's earnings and profits and its business activities in general. A REIT generates earnings and profits. To the extent that it makes distributions out of these earnings and profits, this portion is taxable to unit holders at their ordinary income levels. To the extent that the REIT makes distributions that result from the sale of capital assets -- such as buildings -- this portion will be taxable to unit holders at long term capital gains rates. Finally, to the extent that the REIT makes distributions in excess of earnings and profits, this portion constitutes a return of capital. Why would a REIT make a distribution in excess of earnings and profits? There are a variety of reasons. A REIT that suffered a sharp decline in funds from operations, for example, might make a distribution with an unusually large "return of capital" component. REITs tend to avoid cutting back on distributions. As a result, a REIT facing a fairly unprofitable year but with a traditionally high distribution rate would necessarily need to draw on investors' capital to make the distributions.
Now, the specific tax treatment of the return of capital portion is nuanced and can bemuddle investors. Although some describe the return of capital portion as "tax exempt," this isn't quite correct. In reality, ROC distributions are tax-deferred. Specifically, the ROC portion reduces your adjusted basis in the REIT. As a result of the reduced basis, you will realize a larger capital gain when you sell the REIT (assuming you sell it for a gain). For example, suppose you bought Federal Realty Investment Trust (FRT) for $100. Now suppose FRT makes a $.50 distribution, 100% of which consists of return of capital. This distribution reduces your cost basis in the stock to $99.50. If you then sold FRT for $105, you would realize a capital gain of $5.50 (i.e. $105 - $99.50). The tax on the return of capital distribution was effectively deferred until you sold the stock. What happens if your tax basis is reduced to zero? At that point, the return of capital distributions are no longer deferred -- because you cannot have a negative basis -- and so they become taxable at long term capital gains rates upon receipt (assuming you're a cash-basis taxpayer).
At this point, from a tax planning standpoint, it should be clear that a key question when dealing with REITs is, "How much of the distributions tend to consist of return on capital, capital gains, and ordinary income, respectively?"
The answer to this question is REIT specific. But in general, the ordinary income portion tends to predominate. In recent years, the average breakdown is approximately 70% ordinary income, 15% return of capital, and 15% capital gains (see National Association of Real Estate Investment Trusts). But notice that the size of each portion varies year-by-year (and REIT by REIT). While REITs, on average, tend to make distributions that predominantly receive ordinary income treatment, certain years may witness distributions with return of capital or capital gains making up an uncharacteristically large portion of the distributions.
REITs, Planning, and Your Portfolio
Now that you understand the taxation of REIT distributions, here are a few points on tax-planning to keep in mind when investing in REITs:
REITs are costly from a tax standpoint. Because REIT distributions (1) tend to be taxed predominantly at ordinary income levels and because (2) REITs must distribute the vast majority of their taxable income to maintain their REIT status, REITs are quite inefficient from a tax standpoint. REITs can become even more tax inefficient at the state level. In certain states, REIT unit holders must pay additional state taxes such as a sales and use tax, depending on the REIT's activities. For middle to high-bracket taxpayers who are not near retirement, holding REITs in a taxable account isn't a wise tax move.
Consider holding REITs in a Roth IRA, if possible. For many investors, investing in REITs in a Roth IRA is akin to tax nirvana. First, the REIT distributions accumulate tax free. This lets the investor avoid the ordinary income tax treatment of distributions (and it lets him avoid the capital gains tax on capital gains distributions and on the sale of the REIT). Second, unlike a traditional IRA, the capital gains distributions are not "converted" to ordinary income when the funds are withdrawn from the Roth IRA. Rather, assuming the withdrawal is made after the owner reaches the required age, withdrawals are made tax free. As a result, the investor effectively avoids taxation on the distributions forever. Third, non-mortgage REITs are generally not subject to UBTI when held in a tax-advantaged account (unlike MLPs, for example). Obviously, holding REITs in a Roth IRA is not appropriate for all investors. An investor should consider his individual preferences, tax bracket, liquidity concerns, retirement goals, and other needs before opening a Roth IRA (or before converting an IRA into a Roth IRA). Talk with a financial planner, tax advisor, and/or do your own research before making such a decision.
Compare after-tax yields. Keep taxes in mind when looking at REIT yields. This is tricky, at times, because the after-tax yields depend on the breakdown of the REIT distributions. Even so, it's important to keep in mind that taxes reduce the yield on REITs. Particularly for high-bracket taxpayers holding REITs in taxable accounts, consider comparing the after-tax yield on REITs with that of other investments, such as MUB. A REIT that seems like the best investment pre-tax may become a less attractive investment after-tax.
Beware interest rate risk. Many investors fail to realize that REITs are subject to interest rate risk (with the interest rate risk of mortgage REITs being particularly acute). Investors can minimize this risk by holding other investments that have less interest rate exposure. There are many ways to diversify the interest rate risk posed by REITs; cash, SHY, individual dividend-paying stocks, or an index fund such as VTI are merely a few options.
Taxes cut into your yield and rob you of returns. By understanding the taxation of REIT distributions, you can better choose individual REITs and construct your portfolio in the most tax-efficient manner.