Real estate investment trusts (REITs) let you earn income from diversified real estate portfolios — commercial buildings, apartments, data centers, cell towers, warehouses — without owning or managing a property yourself. The trade-off: REIT dividends are taxed differently than most investment income, and understanding the tax mechanics before investing matters for after-tax returns.
What is a REIT?
A REIT is a company that owns, operates, or finances income-producing real estate. Congress created the REIT structure in 1960 to give individual investors access to large-scale, diversified real estate with the liquidity of a publicly traded stock.
To qualify for REIT status, a company must meet strict rules under the Internal Revenue Code. The IRS specifies the requirements: at least 75% of total assets must be in real estate, mortgages, government securities, or cash; at least 75% of gross income must come from real estate rents, mortgage interest, or property sales; and the REIT must distribute at least 90% of its taxable income to shareholders each year to retain its tax-advantaged status.
The 90% distribution requirement is why REITs typically pay above-average dividends. Because they must pass most income out to shareholders, they retain little cash for internal growth — which is also why REITs frequently issue equity to fund new acquisitions.
Types of REITs
Equity REITs own and operate physical properties. They generate income primarily from rent. Sectors include office, residential/multifamily, industrial, retail, healthcare, self-storage, data centers, and cell towers. The majority of publicly traded REITs are equity REITs.
Mortgage REITs (mREITs) don’t own physical property. They hold mortgages or mortgage-backed securities and earn income from the interest spread between their borrowing costs and the mortgage yields they collect. mREITs are more sensitive to interest rate changes than equity REITs — rising rates compress their spreads and can reduce distributions quickly.
Hybrid REITs combine both property ownership and mortgage lending. Less common than the other two types.
Access structures matter:
- Publicly traded REITs are listed on major stock exchanges. You buy and sell shares through any brokerage account, the same way you trade stocks. Most liquid and transparent.
- Non-traded REITs are registered with the SEC but don’t trade on exchanges. They’re illiquid, often carry high upfront fees, and are sold through broker-dealers. The SEC has published an investor bulletin on non-traded REIT risks that covers the most common pitfalls.
- Private REITs are not SEC-registered. Available only to accredited investors. Highest risk and lowest liquidity.
For most individual investors, publicly traded equity REITs — bought through index funds or directly through a brokerage — are the relevant form.
How REIT dividends are taxed
This is where REIT investing departs significantly from owning stocks. Understanding the three dividend categories before investing is essential for accurate after-tax return projections.
The SEC’s investor education resource on REITs describes the three categories of distributions investors should watch for:
1. Ordinary income dividends. The majority of REIT distributions are taxed as ordinary income — at your marginal federal income tax rate, which runs up to 37% for high earners. This is different from most S&P 500 stock dividends, which qualify for the lower 0%/15%/20% capital gains rates. REIT income is ordinary because it flows through from rents and interest that weren’t taxed at the corporate level first.
2. Qualified dividends. A smaller portion of some REITs’ distributions may qualify as qualified dividends if the REIT itself received qualified dividend income from equity positions it holds. This portion is taxed at the lower long-term capital gains rates.
3. Return of capital. Some REIT distributions represent return of capital — a partial refund of your invested principal rather than earned income. Return of capital distributions aren’t taxed in the year received, but they reduce your cost basis in the REIT. When you eventually sell, the lower cost basis produces a larger taxable gain.
Each year, your REIT or fund issues a Form 1099-DIV that breaks distributions into these categories. Don’t assume the full distribution is ordinary income — read the 1099 carefully before filing.
The Section 199A deduction on qualified REIT dividends
The effective tax rate on REIT ordinary dividends is lower than the headline rate suggests, thanks to the Section 199A deduction.
The IRS explains the Section 199A deduction in its official FAQ: eligible taxpayers can deduct up to 20% of qualified REIT ordinary dividends from their taxable income. This was introduced by the Tax Cuts and Jobs Act of 2017 alongside the broader qualified business income (QBI) deduction for pass-through business owners.
Key distinction: the REIT component of Section 199A has no W-2 wage limitation. Unlike the QBI deduction for business owners — which phases out based on the business’s payroll and qualified property at higher income levels — qualified REIT dividends get the 20% deduction regardless of whether you own a business. The deduction is still subject to overall taxable income limitations.
How the math works:
If you receive $10,000 in ordinary REIT dividends and your marginal rate is 32%:
- Without Section 199A: $10,000 × 32% = $3,200 tax
- With Section 199A (20% deduction): $8,000 taxable × 32% = $2,560 tax
- Effective rate: 25.6% instead of 32%
At the 37% top bracket, the effective rate on qualified REIT ordinary dividends falls to 29.6%.
Selling REIT shares: capital gains
When you sell REIT shares at a profit, the gain is taxed as a long-term capital gain (0%, 15%, or 20%) if held over a year, or short-term (ordinary income rates) if held under a year.
There’s an additional layer: Section 1250 unrecaptured gain, taxed at up to 25%. When a REIT sells property at a profit, the portion of that gain attributed to prior depreciation deductions on the real estate is taxed at up to 25% when passed through to investors as a capital gain distribution. This appears on your 1099-DIV labeled “Unrecaptured Section 1250 Gain” and is calculated separately from the standard long-term capital gains rates.
REITs vs. direct rental property
Both give you real estate income, but the mechanics differ significantly.
| Publicly traded REIT | Direct rental property | |
|---|---|---|
| Liquidity | High — sell shares in seconds | Low — months to sell |
| Minimum investment | Share price (often $20–$80) | Down payment + closing costs |
| Diversification | Automatic across dozens of properties | Concentrated in one property |
| Management burden | None | Active or property manager fees |
| Depreciation deduction | Passed through indirectly | Direct deduction on Schedule E |
| 1031 exchange eligible | No (shares, not direct property) | Yes — defer capital gains indefinitely |
| $25K passive loss allowance | No direct equivalent | Available if active participant, phased out $100K–$150K MAGI |
Direct rental property gives you more tax levers — depreciation deductions, the $25,000 passive activity loss allowance, and 1031 exchange deferral. REITs trade those mechanics for liquidity, diversification, and zero management. Neither is strictly superior; the right answer depends on capital, tax situation, and time.
For direct rental property tax mechanics, see our rental property depreciation guide and 1031 exchange rules overview.
Tax-location strategy: where to hold REITs
Because most REIT dividends are taxed at ordinary income rates, the account where you hold them has a large effect on after-tax returns.
Roth IRA or Roth 401(k): Best account for REITs. Qualified withdrawals are entirely tax-free, which eliminates the ordinary income tax on REIT dividends permanently.
Traditional IRA or 401(k): Defers the ordinary income tax until withdrawal. Meaningful benefit for investors in high tax brackets now who expect to be in a lower bracket in retirement.
Taxable brokerage: The Section 199A deduction softens the tax drag — but REIT dividends will still be taxed at your marginal rate annually. Reasonable choice if your tax-advantaged accounts are already allocated to other assets, or if you need the REIT income accessible before retirement age.
For the broader account-selection framework, see our Roth IRA vs. Traditional IRA guide and our capital gains tax overview.
How to invest in REITs
REIT index funds or ETFs: The simplest path for most investors. Broad REIT index funds hold dozens of properties across all major sectors — residential, commercial, industrial, healthcare, infrastructure. Expense ratios on major REIT index funds are typically below 0.20%.
Individual publicly traded REITs: Available through any brokerage account. Before buying a single REIT, research its sector, debt level, funds from operations (FFO) per share, and dividend payout history. FFO — net income plus depreciation and amortization, minus gains on property sales — is the standard REIT profitability metric. Standard net income understates REIT earnings because large depreciation charges reduce it on paper without affecting cash generation.
Non-traded and private REITs: Avoid unless you fully understand the illiquidity, fee structures (upfront commissions of 5–10% are common on non-traded REITs), and valuation opacity. The SEC’s non-traded REIT bulletin covers the specific risks in detail.
If you’re building a diversified portfolio, REIT exposure is typically best achieved through a low-cost index fund held inside a tax-advantaged account, sized to reflect your broader real estate allocation target.
Sources
- IRS — Real Estate Investment Trusts (irs.gov)
- SEC investor.gov — REITs (investor.gov)
- IRS — Section 199A FAQs (irs.gov)
- SEC — Non-Traded REITs Investor Bulletin (sec.gov)
