How REIT Dividends Are Taxed for Individual Investors

REIT dividends are taxed in three separate ways: most are ordinary income taxed at your marginal rate; some portions are long-term capital gains taxed at preferential rates; and the remainder may be a non-taxable return of capital that reduces your cost basis. A single REIT dividend check often contains all three components, and the REIT reports each on Form 1099-DIV each January.

The Three-Part Dividend

When you receive a dividend from a REIT, your broker and the REIT track three components. Most REITs report this breakdown on Form 1099-DIV, which arrives in January and lists each component separately. The three are:

1. Ordinary dividends (Box 1a on Form 1099-DIV)
2. Long-term capital gains distributions (Box 2a on Form 1099-DIV)
3. Return of capital (Box 2b on Form 1099-DIV, though some systems label this as non-taxable distributions)

Each is taxed differently, and the split varies quarter to quarter and year to year, depending on the REIT’s income sources and asset sales.

Ordinary Income Dividends

The majority of REIT distributions are ordinary dividends. These come from the REIT’s operating income: net rent collected, interest earned on mortgages it originates, and other routine business income, minus operating expenses. Because these are not capital gains, they are taxed at your ordinary marginal tax rate—the same rate you pay on wages and interest.

Example: If you are in the 24% tax bracket and receive $1,000 in ordinary REIT dividends, you owe $240 in federal tax (ignoring state and local taxes). This is a significant burden, which is why REIT investors in high brackets often hold REITs in retirement accounts (401k, IRA) to defer or eliminate the tax.

Ordinary dividends are reported on your Schedule D or Form 1040, and are subject to the 3.8% net investment income surtax if your modified adjusted gross income exceeds thresholds ($200,000 single, $250,000 married).

Capital Gains Distributions

When a REIT sells a property at a gain, it realizes a long-term capital gain (assuming the property was held more than one year). Instead of keeping that gain, the REIT must distribute it to shareholders under the 90% distribution requirement. When it does, shareholders receive a capital gains distribution.

Long-term capital gains are taxed at preferential rates: 0%, 15%, or 20% depending on your income level—much lower than ordinary rates. A capital gains distribution of $1,000 in the 15% bracket costs $150 in tax, compared to $240 for ordinary income at the 24% bracket.

This is the tax advantage side of REITs. When a REIT sells an appreciating property—say, bought for $10 million, sold for $15 million—that $5 million gain flows to shareholders as a capital gains distribution. It’s a tax-efficient way to access appreciation, because the REIT itself is not taxed, and shareholders pay the lower capital gains rate.

Box 2a on Form 1099-DIV separates long-term capital gains. Some brokers and tax software further break this into unrecaptured Section 1250 gains (depreciation recapture, taxed at 25%), but long-term capital gains distributions are generally taxed at the preferential rate.

Return of Capital

The third component, return of capital, is the trickiest. It arises because REITs use depreciation deductions to lower taxable income, even though depreciation is not a cash outflow. A REIT might collect $100 million in rent but report only $60 million in taxable income after large depreciation charges. If it distributes $80 million to shareholders (exceeding the $60 million in taxable income), the excess $20 million is a return of capital.

Return of capital is not taxable in the year you receive it. You do not owe tax on that $20 million when you get the check. However, it is not free money—it reduces your cost basis in the REIT shares.

Example: You buy 100 shares of a REIT at $50 per share, for a total cost basis of $5,000. In year one, you receive $200 in dividends, of which $50 is ordinary income and $150 is return of capital. You owe tax on the $50, but your cost basis drops to $5,000 − $150 = $4,850. When you eventually sell the shares, that lower basis means a larger capital gain, which you will owe tax on then. Return of capital is deferred, not eliminated.

If the return of capital exceeds your cost basis (rare but possible in high-yield REITs that distribute more than they earn), the excess is treated as a capital gain in the year it occurs.

Return of capital is often listed on Form 1099-DIV as Box 2b (distributions received that are non-taxable) or separately on the REIT’s tax documents. Keep careful records of return of capital amounts, because they directly affect your cost basis when you file your tax return.

Tracking and Reporting on Your Return

To report REIT dividends correctly:

1. Get the 1099-DIV from your broker or the REIT transfer agent by January 31.
2. Identify the three components: ordinary income (Box 1a), long-term capital gains (Box 2a), and return of capital (Box 2b).
3. Report ordinary income on Schedule B (or directly on Form 1040 if you have few dividends) or included in the dividend section of tax software.
4. Report capital gains distributions on Schedule D. They are treated as long-term capital gains even if you held the shares for less than one year.
5. Reduce your cost basis by the return of capital amounts. Most tax software has a field for this; manually track it if you file on paper.

Why the Split Matters

The three-part structure is the key insight into REIT tax efficiency (or inefficiency, depending on your situation). If a REIT distributes 5% annually and all of it is ordinary income, you lose 1.2% to tax (24% bracket). If half is capital gains, you lose only 0.9%. If 30% is return of capital, you lose just 0.7% to current tax, deferring the rest.

This is why many REIT investors in high tax brackets prefer REITs with high depreciation or frequent sales (generating capital gains), or who hold REITs in tax-deferred accounts where the three-part split becomes irrelevant.

REITs in Retirement Accounts

If you hold REIT shares in a traditional IRA or 401(k), the three-part split is irrelevant. All distributions are deferred (or never taxed, if in a Roth). This is one reason REITs are often held in retirement accounts—the tax drag is eliminated.

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