Because REITs are required by law to pass much of their income directly to investors, REITs generally bypass corporate taxation and, thus, their dividends aren't eligible for the 15 percent dividend-tax rate put in place in 2003. That means investors generally pay taxes at higher ordinary income rates, which can run as high as 35 percent.
That has caused some investors to sidestep REITs as a potential source of income, for fear they will be hit with larger tax bills. For this and other reasons — including the fact that investors fear rising interest rates will hurt real-estate shares — REITs have lost some of their luster in recent months.
Many investors assume that just because the income came from REITs, it must be taxed at high rates. But a recent study says the conventional wisdom that any one REIT will pay out high-tax dividends may be wrong.
New research from the National Association of Real Estate Investment Trusts, or Nareit, found that of the distributions REITs paid to investors in 2004, 37 percent represented income that is taxable at lower rates. More than half of that was taxable as capital gains, which qualifies for a 15 percent tax rate for most investors and as low as 10 percent for others. The other portion largely came from nontaxable distributions — typically return of capital, which, when the shares are sold, is taxed as capital gains, currently a 15 percent rate for shares held for more than a year.
Unfortunately for investors, it is difficult to predict what category of income a REIT will pay out in a given year because the numbers fluctuate sharply, depending upon asset sales and other variables. According to Nareit, the proportion of those distributions attributable to lower-tax-rate items has risen every year since 1998.
