Tax tips for mutual funds


The two types of REIT

REITs are available in two basic varieties, depending on how they make money:

  • An equity REIT owns properties, typically commercial properties. Earn money by collecting rent from tenants and buying and selling real estate.
  • A mortgage REIT is essentially a lender: it finances mortgages, lending loans to borrowers themselves, or buying mortgages from banks that do so. Earn money by collecting payments on those mortgages.

Some REITs are hybrid, involved in both types of business. REITs generally do not pay taxes on their own as long as they distribute at least 90% of their income to shareholders.

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The type of payment determines the tax treatment

Payments from REIT are referred to as “dividends”, but are a little more complicated than the dividends you receive from buying shares. Since REITs generate revenue in different ways, there are three types of dividends:

  • Ordinary income: money obtained from the collection of rents or mortgages.
  • Capital gains: money obtained from the sale of real estate for an amount greater than that paid by REIT.
  • Return of capital: this is essentially the REIT that gives you back some of your money.

In general, “what happens in the REIT” determines the tax treatment. Capital gain distributions, for example, are subject to capital gains tax.

REIT holding in pension plans

If you hold an interest in a REIT as part of a tax-facilitated retirement plan, such as an IRA or 401 (k), the different types of tax treatment don’t really matter. This is because the returns on investments in such plans are not taxed when earned.

With traditional IRAs and 401k plans, you pay income tax when you withdraw money from your account. And if it’s Roth IRA or Roth 401 (k), you don’t pay any levy tax. When you extract money from one of these retirement accounts, it doesn’t matter if it was a dividend, a capital gain or a return on capital because all distributions are generally considered to be ordinary income.

Decoding your 1099-DIV

If you own shares in a REIT, you should receive a copy of the IRS 1099-DIV form every year. This tells you how much you received in dividends and what kind of dividends they were:

  • Dividends for ordinary income are shown in box 1.
  • Capital gains distributions are generally shown in Box 2a.
  • Return payments are shown in Box 3.

The instructions on 1099-DIV indicate how to report each type of payment in the tax return.

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Ordinary income distributions

Dividends from REIT are almost always ordinary income. Box 1 of the 1099-DIV, in which a REIT reports these dividends, has two parts:

  • Box 1a shows “ordinary dividends” or total dividends. These will normally be taxed at your normal income tax rate, the same as a job’s wages, unless part or all of them are “qualified dividends”.
  • Box 1b shows “qualified dividends”. These qualifying dividends are included in the amount shown in box 1a and do not add to the amount in box 1a. This portion of qualified dividends is taxed at lower capital gains rates. In general, dividends from REIT are automatically exempt from qualified dividends. The qualification of the dividends depends on the nature of the investment that yielded the money transferred to the shareholders.

Capital gains distributions

Normally, capital gains are taxed as short-term gains or long-term gains, depending on the term of ownership of the investment. Tax rates on short-term profits, those resulting from investments held for less than a year, are considerably higher than the long-term rates.

However, individual investors always report distributions of capital gains from REIT as long-term gains, regardless of how long they have had money in REIT.

Return of capital

Some dividends of a REIT are considered a return on capital, which means that you are recovering part of your invested money. These dividends are not taxed at all, since they are just “your” money. However, these dividends reduce the cost base in the REIT investment. The result is that when you sell your REIT shares, you will have a higher taxable capital gain. In other words, repayment of capital does not mean taxes now, but potentially a larger tax thereafter.

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