One of the most common questions we are asked is “how much will I owe in taxes?”
While the answer is complex and varies from investor to investor, this blog post will provide a basic example of how much a hypothetical Fundrise investor might owe in federal taxes in a given year. The following is purely a hypothetical, is for informative purposes only, and does not purport to be representative of any individual investor’s experience.1
At Fundrise, our ultimate goal is to maximize investors’ risk-adjusted returns - and structuring our investments to optimize tax efficiency is a core component of this strategy. As a result, most of the investments in our plans are structured as real estate investment trusts (REITs). As an investor in a REIT you should receive a 1099-DIV tax form, which includes information on dividends paid to you in a given tax year. Depending on the results of operations, REIT dividends may be categorized as ordinary dividends, qualified dividends, or a return of capital, all of which are taxed at different rates.2 In a given year, an investor’s dividend may comprise a combination of each of these types of dividends. For example, in 2017 the East Coast eREIT’s dividend was considered part ordinary dividend and part return of capital.
Let’s look at a hypothetical Fundrise investor named Heather who invested in the East Coast eREIT to see how these different types of distributions impacted her investment’s tax liability.
Ordinary dividends are shares of a REIT’s profits passed on to shareholders that are taxed as ordinary income. As a result, the amount an investor pays will vary based on their personal tax bracket. As of 2018, individuals and those filing a joint tax return may pay between 10% and 37% on their dividends at the federal level. Our investor Heather falls in one of the middle tax brackets and pays 24% in federal taxes on her annual income.
Ordinary and Qualified Dividends as of the Tax Cuts and Jobs Act of 2018:
|Individual Income||Joint Income||Ordinary Income Rate3||Capital Gains Rate4|
|Up to $9,525||Up to $19,050||10%||0%|
|38,701 to $82,500||$77,401 to $165,000||22%||15%|
|$82,501 to $157,500||$165,001 to $315,000||24%||15%|
|$157,501 to $200,000||$315,001 to $400,000||32%||15%|
|$200,001 to $500,000||$400,001 to $600,000||35%||15%|
|over $500,000||over $600,0000||37%||20%|
Heather’s tax bracket is highlighted in green.
For this hypothetical tax year, Heather’s investment in the East Coast eREIT earned approximately $125 in dividends. In 2017, 56.58% of the East Coast eREIT’s dividend was considered an ordinary dividend, so let’s assume that applies to Heather’s dividend as well. This means that Heather would only pay her normal 24% federal tax rate on 56.58%, or $70.73, of her total dividend, for a total before state tax liability of approximately $16.98. We will discuss taxes for the remainder of her dividend below.
Qualified dividends are taxed at the long-term capital gains rate. Based on the historical operations of our eREITs, we do not anticipate they will declare qualified dividends. Generally it is uncommon for REITs to issue qualified dividends. This is because for dividends to qualify for the capital gains rate, the income generally would already have had to be taxed which is not the case for REITs, since one of their main advantages is that they do not pay taxes at the fund level. The amount an investor pays in capital gains tax will also vary based on their tax bracket and annual income. Since the Tax Cuts and Jobs Act (TCJA) of 2018, these brackets were changed to 0%, 15%, and 20%, as can be found in the chart above.
Since no dividends were qualified, this did not impact Heather’s Fundrise investment.
Non-Dividend Distribution (Return of Capital)
REITs may also declare non-dividend distributions, also known as a “return of capital.” A non-dividend distribution reduces the shareholder’s cost basis and is ultimately taxed as a capital gain when the investor redeems their investment.5 6 Capital gains are generally taxed at a lower rate, so a non-dividend distribution may be beneficial from a tax savings prospective in the long run. In addition, it is almost always advantageous to defer tax payment so that money can be invested or spent elsewhere instead of paid to the IRS today.
Reasons for declaring a non-dividend distribution may include claiming depreciation deductions for assets within the fund, or the over-distribution of taxable income, since dividends are typically declared prospectively for REITs, and may not precisely match the amount of taxable income ultimately earned by the fund for the given tax year.
In the 2017 tax year, 43.42% of the the East Coast eREIT’s dividend (the remaining portion of Heather’s dividend that is not considered an ordinary dividend) was considered a non-dividend distribution and was not immediately taxable. As a result, Heather did not immediately owe taxes on $54.28 (or 43.42%) of her $125 dividend from the East Coast eREIT in the 2017 taxable year.
Since Heather would not immediately owe taxes on the non-dividend portion of her dividend, and would owe 24% on the ordinary dividend portion, in this example she would owe about $16.98 in federal taxes to the IRS in 2017 for her East Coast eREIT investment. Heather would eventually owe taxes on any non-dividend distributions when she redeems her investment - however, it would be taxed at a potentially lower capital gains rate.
Share (Principal) Taxation
In addition to the dividends she received, let’s assume the estimated net asset value of Heather’s shares also appreciated in value by a total of $84.50.
However, Heather would not pay taxes on the additional $84.50 in 2017 unless she were to redeem or otherwise dispose of her investment at that increased price (which is not guaranteed). This is because on a 1099-DIV form, you are only taxed on cash that is being distributed for the given tax year. Increases or decreases in the NAV are not recognized from a tax perspective until you redeem or otherwise dispose of your investment.
For any year that the East Coast eREIT declares a non-dividend distribution, as we’ll recall, Heather will not immediately pay taxes on that portion of her dividend. Upon redemption of her investment, all of her non-dividend distributions would reduce her initial cost basis, resulting in a higher capital gain. This value would then be taxable at a long-term capital gains rate instead of the normal federal tax rate for ordinary income, which is frequently preferential from an investor’s standpoint. From the previous chart, you’ll see that some investors may not even pay taxes on this amount if they fall under the 0% capital gains bracket for federal taxes.
At the end of the year, Heather took home $108.03 in dividends and only paid $16.98 in federal taxes on her Fundrise investment. She was not immediately liable for taxes on the non-dividend distribution portion of her dividend, but will eventually pay taxes on this $54.28 amount at the lower capital gains rate (15%) when she redeems her investment (this will cost her another $8.14 in taxes at that time, assuming her tax bracket does not change). In addition, Heather also did not immediately owe taxes on the estimated appreciation in value of her shares. These taxes are also assessed when she ultimately disposes of her investment, and will depend upon the value that she receives for her shares at that point in time (which may be more or less than the estimated NAV).
Please note that it is important to consult your CPA or financial advisor for tax information specific to you, as individual circumstances may vary. The above example is of a hypothetical Fundrise portfolio and is not intended to serve as specific guidance for individual investors. For an additional high-level discussion on tax-related topics, please see here and here.