Pay Less REIT Taxes: Section 199A Dividends

How to Save Taxes on Your REIT Investments with Section 199A Dividends

Introduction

Welcome to Bottomline Tax! If you are looking for a way to invest in real estate without the hassle of managing properties, tenants, and mortgages, you might want to consider real estate investment trusts (REITs). REITs are companies that own, operate, or finance income-producing real estate. They offer several benefits for investors, such as diversification, liquidity, income, and growth. However, REITs also have some unique tax characteristics that can affect your bottom line.

In this article, we will explain one of the most important tax concepts to understand when investing in REITs: the Section 199A Deduction. This is a special deduction that allows you to reduce your taxable income by 20% of the amount of certain REIT dividends you receive. This can lower your tax rate significantly and increase your after-tax return.

Next we’ll discuss what REITs are, how they work, and how they are taxed. We will also show you how to report and deduct Section 199A dividends on your tax return. Finally, we will provide some advice for different types of professionals who are interested in REIT investing.

What is the Section 199A Deduction?

The Section 199A deduction is a tax benefit for owners of pass-through businesses, such as sole proprietorships, partnerships, S corporations, and LLCs. It allows them to deduct up to 20% of their qualified business income (QBI) from their taxable ordinary income. QBI is the net amount of income, loss, gain, and deduction from a qualified domestic trade or business. The deduction is temporary and available from 2018 to 2025. It was enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2017, to provide tax relief to pass-through businesses in response to the reduction of the corporate income tax rate from 35% to 21%.

The Section 199A deduction is subject to two limitations that may reduce or eliminate the deduction for some taxpayers. The first limitation is the wage and qualified property limitation (WQP), which reduces the deduction based on a formula involving the owner’s share of a business’s W-2 wages and the original cost of its qualified assets. The second limitation is the specified service trade or business limitation (SSTB), which reduces the deduction for owners of certain professional service businesses, such as health, law, accounting, consulting, etc. The WQP and SSTB limitations phase in when the owner’s taxable income exceeds a lower income threshold ($364,200 for joint filers and $182,100 for other filers in 2023) and are fully effective when the taxable income exceeds an upper income threshold ($464,200 for joint filers and $232,100 for other filers in 2023).

What are Section 199A Dividends and Why Do They Qualify for the Deduction?

Section 199A dividends are dividends paid by real estate investment trusts (REITs) that are eligible for the Section 199A deduction. REITs are companies that own and operate income-producing real estate properties, such as office buildings, shopping malls, apartments, hotels, etc. REITs distribute most of their taxable income to their shareholders as dividends. REIT dividends are treated as QBI for the purpose of the Section 199A deduction, regardless of the taxpayer’s income level or the nature of the REIT’s business. This means that REIT investors can reduce their tax liability on their REIT dividends by up to 20%, effectively lowering their effective tax rate on those dividends.

Section 199A dividends qualify for the deduction because they are considered income from a qualified trade or business under IRC Section 199A. Unlike other pass-through businesses, REITs do not have to meet any wage or asset requirements to qualify for the deduction. Moreover, REITs are not subject to the SSTB limitation, even if they provide services in the fields that are normally considered SSTBs. Therefore, REIT dividends are more attractive for investors seeking the Section 199A deduction than other types of pass-through income.

To claim the Section 199A deduction for REIT dividends, taxpayers need to report the amount of Section 199A dividends they receive on Form 1099-DIV in Box 5. This amount represents the portion of REIT dividends that are eligible for the deduction. The deduction is calculated on Form 1040, after taking the standard or itemized deductions. The deduction is the lesser of:

• 20% of the taxpayer’s Section 199A dividends, or
• 20% of the taxpayer’s taxable income, excluding any net capital gains.

Here are some examples of how the Section 199A deduction works for REIT investors in different scenarios:

• Example 1: Alice is a single filer who receives $10,000 in REIT dividends and has a taxable income of $50,000 in 2023. She does not have any QBI from other sources. She can claim a deduction of $2,000, which is 20% of her REIT dividends. Her deduction is not limited by her taxable income or any other factors.
• Example 2: Bob is a single filer who receives $20,000 in REIT dividends and has a taxable income of $100,000 in 2023. He also has a QBI of $50,000 from his sole proprietorship, which is a non-SSTB. He can claim a deduction of $14,000, which is the lesser of 20% of his QBI plus REIT dividends ($14,000) or 20% of his taxable income less net capital gains ($20,000). His deduction is not subject to the WQP or SSTB limitations because his taxable income is below the lower income threshold ($182,100 in 2023).
• Example 3: Carol is a single filer who receives $30,000 in REIT dividends and has a taxable income of $200,000 in 2023. She also has a QBI of $100,000 from her partnership interest in a law firm, which is an SSTB. She can claim a deduction of $12,600, which is calculated as follows: First, she reduces her QBI by 35.8%, which is her RP based on her taxable income exceeding the lower income threshold by $17,900 ($200,000 – $182,100). Her reduced QBI is $64,200 ($100,000 – $35,800). Second, she multiplies her reduced QBI by 20% to get $12,840. Third, she adds 20% of her REIT dividends to get $18,840 ($12,840 + $6,000). Fourth, she compares this amount to 20% of her taxable income less net capital gains ($40,000) and takes the lesser amount as her deduction ($18,840). Fifth, she reduces her deduction by multiplying the difference between her deduction without the WQP limit ($18,840) and her deduction with the full WQP limit ($0) by her RP (35.8%). Her reduction amount is $6,240 (($18,840 – $0) x 0.358). Finally, she subtracts her reduction amount from her deduction without the WQP limit to get $12,600 ($18,840 – $6,240).

Understanding REITs

REITs are corporations that invest in real estate or real estate-related assets. They are required by law to distribute at least 90% of their taxable income to their shareholders as dividends. This way, they avoid paying corporate income tax at the entity level.

There are two main types of REITs: equity REITs and mortgage REITs. Equity REITs own and operate properties that generate rental income. Mortgage REITs lend money to real estate owners or invest in mortgage-backed securities (MBSs) that generate interest income.

REITs offer several benefits for investors, such as:

• Diversification: You can invest in a variety of real estate sectors and markets with a single purchase.
• Liquidity: You can buy and sell shares of REITs on the stock market anytime you want.
• Income: You can receive regular dividends from REITs that are usually higher than the average stock.
• Growth: You can benefit from the appreciation of the underlying properties or mortgages over time.

However, REITs also have some risks that you should be aware of, such as:

• Volatility: The value of REIT shares can fluctuate depending on the market conditions and the performance of the real estate sector.
• Leverage: Some REITs use debt to finance their operations, which can increase their returns but also their risks.
• Taxes: The dividends from REITs are taxed differently than other types of dividends, which can affect your after-tax return.

Tax Implications of REITs

The dividends from REITs are taxed differently than other types of dividends. This is because REIT dividends are not eligible for the preferential tax rates that apply to qualified dividends. Qualified dividends are dividends from domestic corporations or certain foreign corporations that meet certain holding period and other requirements. Qualified dividends are taxed at the same rates as long-term capital gains, which range from 0% to 20%, depending on your income level.

REIT dividends, on the other hand, are taxed at your ordinary income tax rates, which range from 10% to 37%. This means that REIT dividends are usually taxed higher than qualified dividends. However, there is an exception for Section 199A dividends, which are a special type of REIT dividends that can lower your tax rate significantly.

Section 199A dividends are REIT dividends that are not capital gain dividends or qualified dividend income. Capital gain dividends are dividends from REITs that result from the sale or exchange of capital assets. Qualified dividend income is dividend income that meets the requirements to be taxed as qualified dividends, such as dividends from certain foreign REITs.

Section 199A dividends are eligible for the 20% deduction for qualified business income (QBI) under the Tax Cuts and Jobs Act of 2017. QBI is the net income from a qualified trade or business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. The QBI deduction allows you to deduct 20% of your QBI, subject to certain limitations, from your taxable income.

The QBI deduction also applies to 20% of your Section 199A dividends and qualified publicly traded partnership (PTP) income. This means that you can reduce your taxable income by 20% of the amount of Section 199A dividends you receive from REITs. This effectively lowers your tax rate on these dividends by 20%. For example, if you are in the 37% tax bracket and receive $10,000 of Section 199A dividends, you can deduct $2,000 (20% of $10,000) from your taxable income, and pay $2,960 (37% of $8,000) in taxes on these dividends. This results in an effective tax rate of 29.6% ($2,960 / $10,000) on these dividends.

The QBI deduction for Section 199A dividends is not subject to the same limitations that apply to the QBI deduction for qualified trades or businesses. These limitations include the threshold amount ($164,900 for single filers and $329,800 for joint filers in 2021), the phase-out range ($50,000 for single filers and $100,000 for joint filers in 2021), and the wage and property tests (50% of W-2 wages or 25% of W-2 wages plus 2.5% of unadjusted basis of qualified property). These limitations may reduce or eliminate the QBI deduction for some taxpayers who have high-income or low-wage businesses.

However, these limitations do not apply to the QBI deduction for Section 199A dividends. This means that you can claim the full 20% deduction for these dividends regardless of your income level or the nature of your business. The only requirement is that you meet the holding period rule for these dividends, which is at least 45 days during the 91-day period beginning on the date that is 45 days before the date on which such share becomes ex-dividend concerning such dividend.

To compare Section 199A dividends with other types of dividends, see the table below:

Need extra help? Ask a professional

Reporting and Deducting Section 199A Dividends

To report and deduct Section 199A dividends on your tax return, you need to follow these steps:

1. Receive Form 1099-DIV from the REIT that paid you the dividends. This form will show you the total amount of dividends you received and how much of them are Section 199A dividends¹.
2. Report the total amount of dividends on Schedule B (Form 1040), Interest and Ordinary Dividends. Include the name of the REIT and the amount of dividends in Part II¹.
3. Report the total amount of dividends on Form 1040, line 3b¹.
4. The Section 199A deduction for dividends is claimed on Form 8995 or Form 8995-A and then flows through to Line 13 of your Form 1040². This deduction does not lower your marginal tax bracket or income-based phaseouts on things like Roth IRA contributions².

Remember to keep a copy of Form 1099-DIV for your records.

Case Study: Investing in REITs

To illustrate the benefits of investing in REITs, let’s look at a hypothetical example of a person who wants to diversify their portfolio and generate passive income. Suppose that this person has $100,000 to invest and decides to allocate 20% of it to REITs. They choose a REIT index fund that tracks the performance of the FTSE Nareit All Equity REITs Index, which consists of 224 publicly traded REITs in the US. The fund has an expense ratio of 0.12% and pays quarterly dividends.

Assuming that the fund has an annual return of 10%, which is the average return of the index from 1990 to 2020, and that the dividends are reinvested, how much would this person have after 10 years? Using a compound interest calculator, we can find out that the initial investment of $20,000 would grow to $51,875. That’s a gain of 159%, or $31,875.

But that’s not all. The fund also pays Section 199A dividends, which are eligible for a 20% deduction on the taxable income. Assuming that this person is in the 24% tax bracket and that the fund pays 50% of its dividends as Section 199A dividends, how much would they save on taxes? Using a tax calculator, we can find out that the total dividends paid by the fund in 10 years would be $15,938, of which $7,969 would be Section 199A dividends. Applying the 20% deduction, this person would reduce their taxable income by $1,594, which would save them $383 on taxes.

Therefore, the total return of investing in REITs in this case would be $32,258 ($31,875 + $383), or 161%. That’s an impressive result for a passive investment that requires no management or maintenance.

Advice for Different Types of Professionals

If you are interested in investing in REITs, you may benefit from some tips and strategies depending on your role and goals. Here are some suggestions for different types of professionals who deal with REITs.

Individual investors: Tips and strategies for managing taxes on REIT investments

Taking advantage of the tax benefits that REITs offer, such as the 20% deduction for qualified business income (QBI) under Section 199A, can be a smart move for an individual investor. However, it’s also important to be mindful of potential tax pitfalls, including the passive activity loss (PAL) rules, the net investment income tax (NIIT), and the state and local tax (SALT) deduction limitations. Here are some strategies to consider:

• Identifying the Suitable REIT Type: REITs come in various forms – equity, mortgage, hybrid, public, private, and traded or non-traded. Each has unique characteristics, risks, returns, and tax implications. For instance, while equity REITs often generate more QBI than mortgage REITs, they might also trigger more PALs and NIIT. Thorough research and consultation with a financial advisor is recommended before investing in any REIT.
• Keeping Track of QBI Deduction Eligibility: To avail the 20% QBI deduction for REIT dividends, certain requirements and limitations must be met. These include holding the REIT shares for at least 45 days during the 91-day period beginning 45 days before the ex-dividend date. Also, your taxable income level may affect your QBI deduction as it could be phased out or limited if your income exceeds certain thresholds. Regular monitoring of your REIT dividends and income throughout the year is advised, along with consultation with a tax professional to optimize your QBI deduction.
• Planning for PALs and NIIT Exposure: Investing in REITs through a passive activity like a partnership or an S corporation might restrict you from deducting your losses from the activity against your other income unless you have sufficient passive income from other sources. Additionally, you might be subject to the 3.8% NIIT on your net investment income if your modified adjusted gross income exceeds certain thresholds. Evaluating your passive activity status and your NIIT exposure before investing in REITs is crucial.
• Understanding State and Local Tax Implications: Your location and the operation location of the REIT can lead to different state and local tax rules and rates on your REIT income. Some states may conform to the federal QBI deduction rules while others may not. Nonresident investors might be subjected to withholding taxes or required to file state tax returns in some states. Being aware of these implications and complying with relevant tax laws is essential.

Let’s consider a fictional investor who did not follow the tax strategies in 2021 but started following them in 2022. Here’s how their tax liability changed:

Tax Year 2021 (without tax strategies):

• The investor bought 1,000 shares of an equity REIT at $20 per share in January 2021 and received a total of $2,000 in dividends, of which $1,200 was ordinary income, $400 was long-term capital gains, and $400 was return of capital. The investor did not sell any shares in 2021.
• The investor’s taxable income for 2021 was $100,000, which included $50,000 from wages, $10,000 from interest and dividends, and $40,000 from a passive activity that generated a loss of $10,000. The investor’s modified adjusted gross income (MAGI) was also $100,000.
• The investor did not qualify for the QBI deduction on the REIT dividends because they did not meet the holding period requirement. Therefore, their taxable income was not reduced by this deduction.
• The investor could not deduct their passive activity loss against their other income because they did not have sufficient passive income from other sources. Therefore, their taxable income was not reduced by this deduction either.
• The investor was not subject to the NIIT because their MAGI was below the threshold of $200,000 for single filers. Therefore, they did not have to pay the additional 3.8% tax on their net investment income.
• The investor paid state and local taxes on their REIT dividends based on their residence state and the states where the REIT operated. They were able to deduct up to $10,000 of these taxes as an itemized deduction on their federal tax return.

Tax Year 2022 (with tax strategies):

• The investor continued to hold the 1,000 shares of the equity REIT and received another $2,000 in dividends with the same breakdown as in 2021. In addition, they sold 500 shares at $25 per share in December 2022, realizing a long-term capital gain of $2,500.
• The investor’s taxable income for 2022 was the same as in 2021.
• This time, the investor qualified for the QBI deduction on the REIT dividends because they met the holding period requirement and their taxable income was below the threshold. This reduced their taxable income by $320 ($1,200 x 20% + $400 x 20%).
• The investor was able to deduct their passive activity loss against their passive income from the REIT dividends because they were both passive activities. This reduced their taxable income by another $1,600 ($1,200 + $400).
• The investor remained not subject to the NIIT and continued to maximize their SALT deduction.

As you can see, by following these tax strategies in 2022 but not in 2021, the investor was able to reduce their taxable income by an additional $1,920 ($320 + $1,600) in 2022 compared to 2021. This resulted in a lower federal tax liability of about $422 ($1,920 x 22%) in 2022. However, these strategies may not apply to every investor’s situation and may change depending on tax laws and regulations. Therefore, it is advisable to consult with a tax professional before investing in REITs or making any tax-related decisions.

Need Specialized Help with REIT Taxes or Section 199A Dividends?

At Bottomline Tax, we want to give our readers the best information we can compile, however your specific situation as a taxpayer may exceed the contents of this article. We always recommend readers consult a tax professional in case of unresolved questions.

Financial advisors: How to guide clients in their REIT investments

As a financial advisor, guiding clients interested in or already investing in REITs is part of your role. Here’s how you can assist them with their REIT investments:

• Educating on REITs: Explain to your clients the workings of REITs, the types available, and the pros and cons of investing in them. Provide them with relevant information such as market reports, performance data, industry trends, and tax updates. This will help them understand the potential returns, diversification benefits, liquidity issues, fees, expenses, and tax implications of REITs.
• Risk tolerance and investment objectives assessment: Determine your clients’ risk tolerance level and investment objectives based on factors like age, income, net worth, time horizon, financial needs, and preferences. Recommend the appropriate type and amount of REIT investments that suit their profile and goals. Assist them in balancing their portfolio allocation among different asset classes, sectors, geographies, and strategies.
• Portfolio performance monitoring and adjustment: Track your clients’ portfolio performance over time and compare it with their benchmarks and expectations. Review their portfolio periodically and make adjustments as needed based on changes in their circumstances, market conditions, or tax laws. Assist them in rebalancing their portfolio to maintain their desired risk-return profile and diversification level.
• Tax planning and compliance advice: Plan ahead for your clients’ tax obligations and opportunities related to their REIT investments. Ensure they comply with the relevant tax laws and regulations and file their tax returns accurately and timely. Coordinate with their accountants and tax professionals to ensure that they are taking advantage of the available tax benefits and avoiding any tax pitfalls.

Accountants and tax professionals: Key points to remember when handling clients’ REIT investments

As an accountant or tax professional, guiding clients who have invested in or are considering investing in REITs is part of your role. Here’s how you can assist them with their REIT investments:

• REITs Understanding: Familiarize yourself with the different types of REITs such as equity, mortgage, hybrid, public, private, and traded or non-traded. Understand how they are accounted for and taxed at the federal, state, and local levels. Be aware of the specific rules and requirements that apply to REITs.
• Information Verification: Obtain and review the relevant information and documents provided by the REITs to your clients. Verify the accuracy and completeness of the information and identify any errors or discrepancies that may affect your clients’ accounting and tax reporting.
• Accounting and Tax Reports Preparation: Prepare and file your clients’ accounting and tax reports related to their REIT investments in accordance with the applicable accounting standards, tax laws, and regulations. Ensure that your clients’ reports are consistent with the information provided by the REITs and reflect their actual transactions and positions.
• Tax Planning Advice: Advise your clients on how to plan and optimize their tax situation related to their REIT investments. Help them maximize their QBI deduction, minimize their PALs and NIIT exposure, take advantage of any available tax credits or deductions, defer or reduce any taxable income or gains, avoid any double taxation or withholding issues, and comply with any state and local tax obligations or opportunities.

Conclusion

REITs are a popular investment option for many investors who want to diversify their portfolio, generate income, and enjoy tax benefits. However, REITs also come with some challenges and complexities that require careful consideration and professional guidance. Whether you are an individual investor, a financial advisor, or an accountant or a tax professional, you should be aware of the benefits and risks of REITs, the different types of REITs available, and the accounting and tax implications of REIT investments. By doing so, you can make informed decisions and achieve your financial goals.

If you have any questions or concerns about your REIT investments or need any assistance with your accounting or tax matters related to them, you should consult a qualified professional who can provide you with tailored advice based on your specific circumstances.