In brief

• Investors can benefit from several tax advantages of non-listed REITs.
• A portion of the REIT’s monthly distribution can be classified as a return of capital, which may be tax deferred by an estimated 60%-90%.
• The individual tax rate that applies to the ordinary income portion of a REIT’s distribution is reduced by 20% as a result of the Tax Cuts and Job Act.
• Taxes due on return of capital (ROC) distributions are usually deferred until the sale of your REIT shares, when typically lower capital gain tax rates apply.
• REIT investors can avoid “double taxation” that occurs at the corporate and individual shareholder level for non-REIT corporations.

The tax laws applicable to non-listed REITs may reduce, defer or eliminate taxes.¹ We’ll explain each of the potential tax advantages and also provide some hypothetical examples of how they work together.

Understand the different types of REIT distributions and how they are taxed

REIT distributions can be categorized as ordinary income, capital gain or a return of capital (ROC). The tax treatment of each category is different and enables some of the tax efficiency of REITs.

Ordinary income is taxed at your regular personal income tax rate, which is typically higher than the rate for capital gain. However, REIT investors are currently benefitting from a 20% reduction in their individual tax rate for the ordinary income portion of REIT distributions, thanks to the Tax Cuts and Job Act (TCJA) of 2017.² For example, if your tax rate is 37.0%, your effective tax rate for your ordinary REIT dividends would be 29.6%.

Capital gain refers to the profit from selling an investment. Long-term capital gain – earned when you have held an investment for at least a year before selling at an appreciated price – is taxed at a rate that is lower than most of the income tax rates. The highest individual capital gain tax rate is 20%. Therefore, in most cases, it is to your advantage to have income taxed as a capital gain, rather than as ordinary income.

Return of capital (ROC) distributions benefit from real estate-related tax deductions. As real estate vehicles, REITs are able to claim tax deductions for depreciation and amortization, which reduce the REIT’s net taxable income but do not reduce its cash. This feature potentially allows a portion of the distributions REITs pay out to be classified as ROC, rather than dividends taxable as ordinary income or capital gain. The ROC distributions may possibly reduce the taxable portion of distributions by an estimated 60%-90%.³

Here's where ROC diverges from ordinary income and capital gain, from a tax perspective: Instead of being included in your taxable income in the year received, an ROC distribution is accounted for by reducing the tax basis in your REIT shares by the amount of the ROC distribution. As long as the ROC distribution does not exceed your tax basis in your REIT shares, the taxes due on the ROC portion of the distribution are generally deferred until the shares are sold. If a ROC distribution exceeds your tax basis, it is generally taxed as a capital gain, and is taxable as a long-term capital gain if you held the REIT shares for more than a year.

REITs, therefore, have the potential to be relatively tax-efficient investments because of their ability to use ROC distributions to both defer taxes and potentially reduce them to the typically lower capital gain rate.

Explore how ROC can impact the effective tax rate on your REIT investment

The following hypothetical example illustrates how the tax treatment of ROC can improve the tax efficiency of REITs. We compare a non-REIT investment to REIT investments with different percentages designated as ROC.

Tax impact of ROC assuming $100,000 investment and an annualized pre-tax yield of 5% ($5,000 annualized distribution)^3,4

As shown in the above example, when the TCJA REIT rate reduction and ROC of 0%, 60% and 90% are combined with the associated tax rates, the effective federal tax rate may be reduced from 37.0% to 29.6%, 11.8% and 3.0%, respectively, and yields are increased from 3.15% to 3.52%, 4.41% and 4.85%, respectively.

In order to match the 0%, 60% or 90% ROC REIT after-tax yield, a taxable fixed income investor would need to find a 5.6%, 7.0% or 7.7% pre-tax yield investment.

REITs may offer you some additional tax advantages

In addition to the tax efficiency of ROC distributions and the TCJA REIT rate reduction, you should be aware that REITs may offer further tax advantages. First, REITs do not pay U.S. federal corporate income taxes on REIT taxable income distributed to investors, meaning investors avoid the “double taxation” that applies to non-REIT corporations, which are liable for taxes at both the corporate and individual shareholder level.

REIT shares are eligible for a step-up in cost basis upon the death of their owner. This tax feature allows the recipient of inherited shares to sell them with limited tax consequences, if any.⁵

A REIT is required to provide certain U.S. stockholders with an annual Internal Revenue Service (IRS) Form 1099-DIV or IRS Form 1099-B, if relevant, and, in the case of non-U.S. stockholders, an annual IRS Form 1042-S. These forms characterize annual distributions as ordinary income, return of capital or capital gain for tax reporting purposes and should be available to investors up to 45 days after year-end.

Your personal tax situation will be unique from another investor’s. When looking at taxes related to your REIT investment, it is important to work closely with your accountant to determine your cost basis and other relevant tax factors.

¹ Taxes can be reduced due to the 20% deduction permitted on REIT ordinary income distributions through the end of 2025, deferred due to the reduction in the cost basis of your REIT shares due to ROC and eliminated due to step-up in basis upon inheritance. A step-up in cost basis upon inheritance can transfer the inherited shares to the beneficiary without tax if the beneficiary sells those inherited shares at that adjusted cost basis, which would eliminate taxes on that appreciation.
² At this time, the 20% rate deduction to individual tax rates on the ordinary income portion of REIT distributions is set to expire on December 31, 2025.
³ The ROC percent of a distribution may vary significantly based on the depreciation generated by a portfolio’s underlying assets in a given year, as a result, the impact of the tax laws and any related advantage may vary significantly from year to year. The stockholder’s tax basis may be reduced by ROC distributions in the year the distribution is received and generally defer taxes on that portion until the stockholder’s stock is sold via repurchase. Upon repurchase, the investor will calculate their gain by reference to the lower cost basis attributable to the ROC distributions, which gain may be subject to tax at capital gain rates. The illustration does not reflect the impact of increasing net operating income (NOI); an increasing NOI from higher rents would reduce the ROC percentage. This example is provided for illustrative purposes only and is intended to show the likely effects of existing tax laws. There can be no guarantee that the future results will be similar to the illustration provided or that JPMREIT will execute its investment strategy, investment objectives, be profitable or avoid losses. JPMREIT currently believes that the assumptions referenced are reasonable under the conditions, there is no guarantee that the conditions upon which the assumptions are based will materialize or become applicable. This illustration is not a forecast, and all assumptions are conditional upon uncertainties, fluctuations and other risks, any of which may cause the applicable factual, financial and other results to be substantially different from the example provided. This assumption should not be relied on and no assurance, representation or warranty is made that any of the assumptions will be achieved. Stockholders may also be subject to federal net investment income taxes of 3.8% and/or state income tax in the applicable state of residence, which would lower the after-tax yield received by the stockholder.
⁴ Distribution payments are not guaranteed. JPMREIT may pay distributions from sources other than cash flow from operations, including, without limitation, the sale of assets, borrowings, return of capital or offering proceeds, and advances or the deferral of fees and expense reimbursements and JPMREIT has no limits on such amounts it may pay from such sources.
⁵ A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance. The asset receives a step-up in basis so that the beneficiary’s capital gain tax is minimized. A step-up in basis is applied to the cost basis of property transferred at death.