Are REITs tax inefficient?
By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate. Other tax-inefficient investments are REITs, small value funds, and actively managed funds that frequently churn their holdings.
REITs and REIT Funds
Real estate investment trusts are a poor fit for taxable accounts for the reason that I just mentioned. Their income tends to be high and often composes a big share of the returns that investors earn from them, as REITs must pay out a minimum of 90% of their taxable income in dividends each year.
Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.
Dividends can qualify for advantageous capital gains tax treatment if stocks are owned long enough. Avoiding all income taxes on dividends is more complicated, though. Options include owning dividend-paying stocks in a tax-advantaged retirement account or 529 plan.
Fund | Expense ratio |
---|---|
iShares National Muni Bond ETF (MUB) | 0.05% |
Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX) | 0.09% |
Vanguard Short-Term Tax-Exempt Bond ETF (VTES) | 0.07% |
Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX) | 0.17% |
A portion of the REIT's monthly distribution can be classified as a return of capital, which may be tax deferred by an estimated 60%-90%. The individual tax rate that applies to the ordinary income portion of a REIT's distribution is reduced by 20% as a result of the Tax Cuts and Job Act.
The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37% (returning to 39.6% in 2026), plus a separate 3.8% surtax on investment income. Taxpayers may also generally deduct 20% of the combined qualified business income amount which includes Qualified REIT Dividends through Dec.
By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate. Other tax-inefficient investments are REITs, small value funds, and actively managed funds that frequently churn their holdings.
Tax-Efficient Investments
Municipal bonds are very tax-efficient because the interest income isn't taxable at the federal level and it's often tax-exempt at the state and local level, too. 7 Munis are sometimes called triple-free because of this.
One type of trust that helps protect assets is an intentionally defective grantor trust (IDGT). Any assets or funds put into an IDGT aren't taxable to the grantor (owner) for gift, estate, generation-skipping transfer tax, or trust purposes.
How do I pay zero taxes on dividends?
Your “qualified” dividends may be taxed at 0% if your taxable income falls below $44,625 (if single or Married Filing Separately), $59,750 (if Head of Household), or $89,250 (if (Married Filing Jointly or qualifying widow/widower) (tax year 2023).
However, if you are looking for a regular and stable income, then dividends might be a better option. On the other hand, if you are more interested in making short-term profits, capital gains might be a better choice. Ultimately, it comes down to your preferences and the type of company you invest in.
How dividends are taxed depends on your income, filing status and whether the dividend is qualified or nonqualified. Qualified dividends are taxed at 0%, 15% or 20% depending on taxable income and filing status. Nonqualified dividends are taxed as income at rates up to 37%.
Say that a $1,000 face value bond has a coupon interest rate of 5%. No matter what happens to the bond's price, the bondholder receives $50 that year from the issuer. However, if the bond price climbs from $1,000 to $1,500, the effective yield on that bond changes from 5% to 3.33%.
You can skip paying taxes on interest earned with Series EE and Series I savings bonds if you're using the money to pay for qualified higher education costs. That includes expenses you pay for yourself, your spouse or a qualified dependent. Only certain qualified higher education costs are covered, including: Tuition.
Treasuries are generally considered"risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.
The value of a REIT is based on the real estate market, so if interest rates increase and the demand for properties goes down as a result, it could lead to lower property values, negatively impacting the value of your investment.
If you own REITs in an IRA, you won't have to worry about dividend taxes each year, nor will you have to pay taxes in the year in which you sell a REIT at a profit. In a traditional IRA, you won't owe any taxes until you withdraw money from the account.
REITs have many built-in tax efficiencies for investors. For example, they do not pay corporate income taxes, return of capital distributions are tax-deferred and REIT investors can deduct 20% of their dividends earned for the qualified business income deduction.
Although REITs trade on exchanges like stocks, the tax structure for these investments can be much different. For a basic guide on REITs, be sure to check out The Definitive Guide to Real Estate Investment Trusts.
Can REITs pass through losses?
Finally, a REIT is not a pass-through entity. This means that, unlike a partnership, a REIT cannot pass any tax losses through to its investors.
Benefits of investing in REITs include tax advantages, tangibility of assets, and relative liquidity compared to owning physical properties. Risks of investing in REITs include higher dividend taxes, sensitivity to interest rates, and exposure to specific property trends.
Distributions received from a real estate investment trust (REIT) ( ¶2326) not designated as capital gain dividends are generally treated by shareholders as ordinary income to the extent of the REIT's earnings and profits.
The inefficiency is because dividends are an after tax distribution, so the income that is generated to pay those dividends is already taxed at the corporate level, and then the dividend is taxed at the personal level when it is received.
Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became completely worthless during the tax year are treated as though they were sold on the last day of the tax year. This affects whether your capital loss is long term or short term. See Holding Period, later.
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