Can REITs Pass-Through Losses to Shareholders?

Real Estate Investment Trusts (REITs) offer a distinctive investment avenue into the real estate market. Investors often inquire whether these investment vehicles can pass through losses to their shareholders for tax purposes. Understanding their unique tax structure is important for investors. This article will explore the tax framework governing REITs, how these entities manage internal operational losses, and the tax treatment of losses that investors might incur from their REIT investments.

The Tax Framework of REITs

REITs are companies that own, operate, or finance income-producing real estate. Congress established REITs in 1960 to provide all investors the opportunity to invest in large-scale income-producing real estate. To qualify as a REIT, an entity must satisfy requirements outlined in Internal Revenue Code Section 856. These requirements address organizational structure, asset composition, income sources, and distribution policies.

REITs avoid corporate-level income tax, a feature that distinguishes them from typical corporations. This avoidance of double taxation is achieved by distributing a substantial portion of their taxable income to shareholders. REITs are mandated by law to distribute at least 90% of their taxable income annually to their shareholders in the form of dividends.

The “pass-through” nature of REITs primarily refers to this income distribution, allowing earnings to flow through to shareholders without being taxed at the corporate level. This differs from other pass-through entities, such as partnerships or S-corporations, which typically pass through both income and losses directly to their owners. For REITs, the income is taxed only once, at the individual shareholder level. This structure supports current income streams.

To maintain their REIT status, these entities must also meet specific income and asset tests. For instance, at least 75% of a REIT’s gross income must come from real property-related sources like rents or mortgage interest. Similarly, at least 75% of a REIT’s total assets must be invested in real estate assets, cash, or government securities. These rules ensure that REITs remain focused on real estate activities, aligning with their purpose.

How REITs Handle Internal Losses

REITs do not pass their internal operational or net losses directly to individual shareholders. Unlike partnerships, which issue K-1s that often include allocations of losses directly deductible by partners, REITs are structured as corporations for tax purposes, albeit with special conduit treatment for income.

Losses generated within the REIT, such as from property depreciation, operating expenses exceeding revenue, or property write-downs, are retained by the REIT entity. Depreciation, a non-cash expense, is a factor in real estate operations that can reduce a REIT’s taxable income without reducing its cash flow. This allows a portion of REIT distributions to be classified as a “return of capital” rather than fully taxable dividends.

When a REIT experiences a net operating loss (NOL), these losses are not distributed to shareholders. Instead, the REIT uses these internal losses to offset its own future taxable income. REITs can carry forward NOLs to offset taxable income in subsequent years. For NOLs arising in taxable years beginning after December 31, 2017, the deduction is limited to 80% of the REIT’s taxable income in any given year, but these losses can be carried forward indefinitely.

While a REIT might incur losses internally, these losses are utilized at the entity level to reduce its own future tax liabilities. This internal utilization ensures the REIT’s financial stability and compliance with distribution requirements, without directly transferring the tax benefit of losses to individual investors.

Investor Tax Treatment of REIT-Related Losses

Individual investors can experience losses related to their REIT investments when selling shares for less than their original purchase price. This results in a capital loss, treated for tax purposes like capital losses from other stock sales. This type of loss is reported on an investor’s personal tax return.

To report these capital losses, investors use IRS Form 8949, Sales and Other Dispositions of Capital Assets, and then summarize the information on Schedule D, Capital Gains and Losses. Form 8949 details each sale transaction, including the acquisition date, sale date, purchase price (cost basis), and sale price. The totals from Form 8949 are then transferred to Schedule D, where net capital gains or losses are calculated.

Capital losses can be used to offset capital gains realized from other investments within the same tax year. If an investor’s total capital losses exceed their total capital gains, they can deduct up to $3,000 of the net capital loss against their ordinary income in a given tax year. For married individuals filing separately, this limit is $1,500. Any remaining capital losses exceeding this annual deduction limit can be carried forward indefinitely to offset capital gains or ordinary income in future tax years.

Investors should be aware of the “wash sale” rule when realizing losses from REIT shares. This rule disallows a loss deduction if an investor sells shares at a loss and then purchases substantially identical shares within 30 days before or after the sale date. If a wash sale occurs, the disallowed loss is added to the cost basis of the newly acquired shares.