By Julia Santos · Founding Editor, DividendsTimes
Educational analysis, not personalized investment advice.
Most dividend investors know that qualified dividends enjoy a preferential tax rate, but REIT dividends taxed at ordinary income rates can quietly eat a third or more of the cash flow a portfolio generates. According to 24/7 Wall St., three widely held real estate investment trusts illustrate the problem perfectly, and the simplest fix is one account most investors already have access to: a Roth IRA.
In this article
Why REIT dividends taxed at ordinary rates hurt more than you think
Under the Internal Revenue Code, REITs must distribute at least 90% of taxable income to shareholders. That mandate is what makes them attractive to income seekers. The catch is that those distributions are generally classified as ordinary income rather than qualified dividends, which means they are taxed at your marginal federal rate rather than the lower 0%, 15% or 20% bracket reserved for qualified payouts.
For a taxpayer in the 32% or 37% bracket, the difference is severe. A REIT yielding 5% effectively delivers closer to 3.2% after federal tax alone once state taxes are layered on. Over a decade of compounding, that drag can cost tens of thousands of dollars on a six-figure position.
The Section 199A deduction, introduced under the 2017 tax law, does allow many taxpayers to exclude up to 20% of qualified REIT dividends from taxable income. But the deduction phases out at higher income levels, and its future beyond the current legislative window remains uncertain. Income investors counting on that provision should watch the ongoing tax debate in Congress closely.
Three REITs that benefit most from Roth placement
The REITs highlighted by 24/7 Wall St. share a common profile: generous yields, heavy ordinary-income distributions, and broad popularity among retail investors. While the source does not specify exact tickers, the pattern applies to the highest-yielding names in the REIT universe, including mortgage REITs and net-lease operators that pay out nearly all of their earnings.
- Mortgage REITs like Annaly Capital Management (NLY) and AGNC Investment (AGNC) routinely yield above 10% and distribute almost entirely ordinary income.
- Net-lease REITs such as Realty Income (O) pay monthly dividends that are partially ordinary income and partially return of capital, though the ordinary portion still dominates.
- Diversified equity REITs with high payout ratios face the same structural issue whenever distributions exceed their qualified dividend components.
Placing these holdings inside a Roth IRA eliminates the tax drag entirely. Distributions grow and compound tax-free, and qualified withdrawals in retirement owe nothing to the IRS. For investors who plan to hold REITs for decades, the compounding advantage of zero taxation on high-yield payouts is substantial.
How to think about asset location
Tax-efficient asset location, the practice of matching investment types to the right account, is one of the simplest levers income investors can pull. The general framework is straightforward: place tax-inefficient assets (REITs, high-yield bonds, actively traded funds) in tax-advantaged accounts, and hold tax-efficient assets (index funds, qualified-dividend stocks, municipal bonds) in taxable brokerage accounts.
This does not mean every REIT belongs in a Roth. Investors with limited Roth space may need to weigh the yield and tax character of each holding. A REIT yielding 3% with a large return-of-capital component may not justify the Roth real estate over a mortgage REIT yielding 12% with entirely ordinary income.
What to watch
Congress is debating extensions and modifications to the 2017 tax provisions, including Section 199A. Any reduction or elimination of the REIT dividend deduction would make Roth placement even more valuable. Meanwhile, the Federal Reserve’s rate path continues to influence REIT valuations and borrowing costs. Income investors should monitor both legislative developments and interest rate signals when sizing REIT allocations across their accounts.
Frequently asked questions
Why are REIT dividends taxed at higher rates than regular stock dividends?
REITs are required by law to distribute at least 90% of taxable income to shareholders. Because these distributions come from rental income and mortgage interest rather than corporate earnings that have already been taxed, the IRS treats them as ordinary income. That means they are taxed at your marginal rate, which can be as high as 37%, instead of the preferential qualified dividend rate of 0% to 20%.
Can I hold REITs in a traditional IRA instead of a Roth?
Yes, a traditional IRA also shelters REIT dividends from annual taxation. However, all withdrawals from a traditional IRA are taxed as ordinary income in retirement. A Roth IRA is generally more advantageous for high-yield REITs because qualified withdrawals are completely tax-free, preserving the full compounding benefit over time.
Does the Section 199A deduction eliminate the REIT tax problem?
Not entirely. Section 199A allows eligible taxpayers to deduct up to 20% of qualified REIT dividends, which reduces the effective tax rate but does not bring it down to the qualified dividend rate. The deduction also phases out for higher earners and is subject to legislative renewal, making it an unreliable long-term planning tool on its own.
Educational analysis, not personalized investment advice.