Capital Gains Tax on REIT Shares

When you sell REIT shares, the tax treatment of your gain depends on how long you held them and whether part of your return came as return-of-capital dividends rather than true income. Long-term gains on REIT shares are generally taxed as capital gains, but a portion tied to depreciation recapture can be hit with the 25% unrecaptured Section 1250 rate instead.

How REIT Dividends Become Basis Reduction

REIT distributions fall into three buckets: ordinary income (usually the largest), return of capital, and long-term capital gains. The ordinary income portions are taxed in the year paid. But return-of-capital distributions do not trigger immediate tax; instead, they reduce your cost basis in the REIT shares.

This is crucial: if a REIT pays you $200 in total distributions in a year, and $120 is ordinary income and $80 is return of capital, you get a Form 1099-DIV showing the $120. The $80 never appears as income, but you must track it and reduce your basis accordingly. Your broker may not do this automatically. If you paid $1,000 for the shares and received $80 return of capital, your adjusted basis becomes $920.

When you eventually sell, your gain (or loss) is the sale price minus this adjusted basis. This is why return of capital matters: it shrinks the denominator, potentially inflating the gain.

Long-Term vs. Short-Term Gains on REIT Shares

Hold the REIT shares for more than one year before selling, and any gain qualifies for long-term capital gains rates: 0%, 15%, or 20% depending on your ordinary income tax bracket. This is the default assumption for most retail investors who buy and hold REITs in taxable accounts.

If you sell within one year, the entire gain is taxed as ordinary income at your marginal rate, which could be 24%, 32%, 35%, or 37% for higher earners. For REIT investors, the one-year mark is a meaningful line.

The Unrecaptured Section 1250 Complication

Here is where REIT taxation gets its teeth. Unrecaptured Section 1250 gain is a special capital gain that is capped at a 25% tax rate. It arises because the REIT itself claimed depreciation deductions on its real estate holdings and then passed those deductions (or the tax benefit) downstream to you.

Broadly, the IRS rule is this: for any gain on REIT shares that is attributable to depreciation deductions the REIT claimed (and did not recapture through prior sales), 25% of that gain is treated as unrecaptured Section 1250 gain. The remaining portion of your gain is taxed at the long-term capital gains rate.

In practice, a significant portion of your REIT gain typically qualifies as Section 1250 recapture, because REITs distribute most of their taxable income as dividends (required by law), and much of that income reflects depreciation deductions on their buildings and land.

Computing Your Gain: A Numeric Example

Suppose you bought 100 shares of a REIT at $50 per share (cost basis: $5,000). Over five years, the REIT paid the following distributions:

• Year 1: $4 ordinary income, $1 return of capital per share = $500 ordinary, $100 return
• Year 2: $4 ordinary, $0.50 return of capital = $400 ordinary, $50 return
• Year 3: $4.25 ordinary, $0 return = $425 ordinary, $0 return
• Year 4: $4 ordinary, $0.75 return = $400 ordinary, $75 return
• Year 5: $4.50 ordinary, $0.25 return = $450 ordinary, $25 return

Your total return-of-capital distributions: $100 + $50 + $0 + $75 + $25 = $250.

Your adjusted cost basis: $5,000 − $250 = $4,750.

You sell the shares at $65 per share = $6,500 proceeds.

Your total gain: $6,500 − $4,750 = $1,750.

Now, the REIT’s Form 1099-DIV (or its supporting information) should tell you what portion of your distributions were tied to depreciation recapture. If the REIT discloses that $0.80 per share per year was attributable to Section 1250 recapture (often embedded in the ordinary income dividend), you would compute:

$0.80 × 100 shares × 5 years = $400 of unrecaptured Section 1250 gain within your $1,750 total gain.

The remaining $1,350 is taxed at the long-term capital gains rate (0%, 15%, or 20%). The $400 is taxed at 25%.

In practice, REITs don’t always provide this level of detail on Form 1099-DIV, so investors often need to request it or consult the REIT’s annual reports and tax information.

Return of Capital and Its Tax Reality

Return-of-capital distributions are sometimes marketed as “tax-free” income. That framing is misleading. They are not taxed in the year paid, but they reduce your basis and increase your gain when you sell. The tax is deferred, not eliminated.

If a REIT pays high return of capital relative to its dividend yield, it may mean the underlying businesses are not generating enough cash to cover distributions sustainably. Or it may reflect a REIT returning investor capital as a one-time event. Either way, you must track the basis reduction carefully.

How Basis Carryover Works

When you inherit REIT shares, your basis steps up to fair market value on the date of death (under current U.S. law). This eliminates any built-in gain and is why many high-net-worth investors hold REITs through their lifetime and pass them to heirs. The heirs receive a stepped-up basis and can sell immediately with minimal or no gain.

If you donate REIT shares to charity, you can deduct the fair market value on the donation date, and the charity receives the shares with no gain; you avoid the capital gains tax but lose the basis deduction you would have had if you’d sold and donated cash.

Tax-Loss Harvesting and REIT Shares

REIT shares can fall in price, creating losses. You can harvest those losses to offset other capital gains (or up to $3,000 of ordinary income per year, with excess losses carrying forward). The wash-sale rule applies: if you buy substantially identical REIT shares within 30 days before or after the sale, the loss is disallowed and added to the basis of the new shares.

Some investors systematically sell underwater REIT positions in December to lock in losses and then buy them back after the 30-day window. This is legal, though it requires discipline and attention to transaction costs.

See also