How much does the return of capital component change the case for holding REITs in a taxable account?

Question

Consider an investor whose tax advantaged space is close to full, so the incremental dollar has to go into a taxable brokerage account. The standard line is that REITs belong in tax advantaged accounts because most of the distribution is ordinary income and only a small part is qualified dividend, and the mechanism is not in dispute. The question is how much that guidance is actually worth in basis points once the components are examined. A REIT distribution is several things at once. Part is ordinary income, part can be return of capital that reduces basis and defers the tax until sale, and part can be capital gain distribution. The mix varies by REIT and by year, and it shows up on the 1099-DIV after the fact, sometimes late enough that the investor has already filed an extension waiting on it. On a 5 percent yield with, say, half the distribution ordinary income at a high marginal rate, the drag is real, yet it is well short of the whole 5 percent taxed at the top rate that the simple version implies. So, for people who have held listed REITs in taxable accounts across several years, how much does the return of capital component move the needle? And is there a way to estimate the mix in advance from disclosures, instead of discovering it in February? The paperwork that says this ahead of time is the paperwork nobody seems able to find.

Rena Expert · Accepted Answer

There isn't a reliable forward-looking disclosure of the character split, and that's the structural answer to your second question. The character of a distribution depends on the REIT's taxable income for the full year, which depends on depreciation, gains on dispositions, and whether they used a taxable REIT subsidiary. None of that is settled until the books close. Some REITs publish an estimated tax character in investor materials before year end and most of them attach language saying it's an estimate. The historical mix, which you can pull from several years of prior tax-character statements on a REIT's investor relations page, is the closest thing to a predictor, and it's a decent one for a stable portfolio and a bad one for a REIT that just sold a large asset.

On magnitude: the return-of-capital share is largely a function of how much depreciation the REIT is carrying relative to cash flow. Owners of long-lived assets with heavy depreciation and modest gains tend to run higher return-of-capital percentages, and that portion defers rather than eliminates the tax, because it lowers your basis and comes back as gain on sale. If you're a genuine long-term holder that deferral has value. If you rebalance every couple of years it's mostly noise.

The assumption I'd push on is that account placement is the biggest lever here. It usually isn't. Sector selection and entry valuation swing outcomes far more than a few dozen basis points of tax drag, and the current setup, with valuations depressed against both equities and private marks and new supply tightening in apartments, industrial and storage, argues the placement question is second order. Also, if any of your holdings are foreign-listed or hold non-US assets, withholding and treaty treatment complicate this in ways a tax professional needs to look at directly.

tashaford30 · Answer

The February problem is the part that pushes many investors out of individual REITs in taxable accounts. Waiting on corrected 1099s from three different issuers to file one return rarely justifies whatever basis points the position was earning.

tylerbrooks9 · Answer

A common answer to this question is to hold a broad REIT index fund in taxable if that is where the room is, since the character mix across dozens of holdings is more stable year to year than any single name. It is a reasonable position. What you give up in precision you get back in predictability, which counts for something when you are planning around the number.

priya_n21 · Answer

@tylerbrooks9 that is the standard view, though the fund itself passes through the same ordinary income character, so you smooth the surprise without removing the drag. For an investor whose goal is the income without a second job, a known tax drag is usually the better trade than a phone call about a broken water heater.

ehernandez74 · Answer

On the estimating question, @wendy_park48, some REITs put a tax character table going back five or six years in the investor section. Those tables are useful for spotting a pattern and unreliable for precision. It is common to see a name run 30 to 40 percent return of capital for four straight years and then almost none in a year with big dispositions, which is exactly the case @rena-expert flagged.

mitchell_ray4 · Answer

My whole background is trades, so I didn't know a dividend had a character at all. So the same 5 percent can be taxed three different ways depending on what the company did internally that year?

How much does the return of capital component change the case for holding REITs in a taxable account?

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