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Investors seeking passive income often choose between real estate investment trusts (REITs) and dividend stocks, both of which provide regular payouts. However, their tax treatment differs and can impact overall returns. A financial advisor can explain the tax differences between REITs and dividend stocks and help you choose an option for your portfolio.
Real estate investment trusts are structured as pass-through entities, meaning they do not pay corporate income tax as long as they distribute most of their earnings to shareholders. This allows investors to receive high dividend payouts, but those distributions are taxed differently than traditional stock dividends.
REIT dividends are typically divided into three categories for tax purposes:
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Ordinary income dividends. The majority of REIT distributions fall into this category and are taxed at the investor’s regular income tax rate, which can be as high as 37% for top earners.
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Capital gains distributions. A smaller portion of REIT dividends may be classified as long-term capital gains, which are taxed at reduced rates of 0%, 15% or 20%, depending on the investor’s income level.
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Return of capital (ROC). Some REIT distributions are classified as return of capital, which is not taxed immediately. Instead, it reduces the investor’s cost basis in the REIT, deferring taxation until the shares are sold.
Dividend stocks distribute profits to shareholders in the form of cash payments, which can be classified as either qualified or non-qualified dividends for tax purposes. The way these dividends are taxed depends on whether the stock meets the criteria for qualified dividend treatment.
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Qualified dividends. These are taxed at the favorable long-term capital gains rate of 0%, 15% or 20%, depending on the investor’s income. To qualify, the investor must hold the stock for at least 60 days within the 121-day period surrounding the dividend’s ex-dividend date.
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Non-qualified dividends. These are taxed as ordinary income at the investor’s marginal tax rate, similar to REIT dividends. This typically applies to dividends from certain foreign corporations, REITs and some business development companies.
REITs and dividend stocks are taxed differently, impacting an investor’s after-tax income and total return. Here are five distinctions you should consider between both of them:
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Ordinary income taxation on REITs vs. lower tax rates for qualified dividends. The majority of REIT distributions are taxed as ordinary income, which can be as high as 37% for top earners. Qualified dividends from traditional dividend stocks, comparatively, are taxed at the lower long-term capital gains rate, which ranges from 0% to 20%, depending on income level. This makes dividend stocks generally more tax-efficient in taxable accounts.
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Return of capital advantage in REITs. Some REIT dividends are classified as return of capital, which defers taxation by lowering the investor’s cost basis. This can provide a tax advantage in the short term, but taxes will eventually be owed when the REIT shares are sold. Dividend stocks typically do not offer this benefit.
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Best account placement for tax efficiency. Because REIT dividends are taxed at higher rates, they are often best held in tax-advantaged accounts like IRAs and 401(k)s, where taxes on dividends can be deferred or avoided. Dividend stocks that pay qualified dividends can be more tax-efficient in taxable brokerage accounts.
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REITs must distribute 90% of taxable income. REITs are required by law to distribute at least 90% of their taxable income to shareholders, which often results in high dividend yields. Traditional dividend stocks have more flexibility and may choose to retain a portion of earnings for growth, rather than distributing them to investors.
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Potential for long-term capital appreciation. While REITs primarily provide income through dividends, many dividend-paying stocks offer both income and long-term capital appreciation. Stocks of established companies that increase dividends over time can provide both growth and income benefits for investors.