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I hear a lot of recommendations that I should hold my healthcare REITs in tax-advantaged accounts. The theory is the taxman will hit us hard if we hold these assets in taxable accounts. That’s because REITs shell out nonqualified dividends that get taxed like regular income. I touched on this briefly when I talked about where I keep my medical office buildings. At the time of writing that post, as recommended, I was holding almost everything in my tax-advantaged Roth and Traditional IRA accounts. Back then, I didn’t need to worry about income taxes or how they would be applied to my REIT dividend income.
But Max strictly follows the policy of ‘trust but verify’. So I purposely generated $100 in taxable REIT dividend income in my brokerage account in 2019. That way, I could follow it through to my tax return and see how much the IRS pulled out of my pocket.
I used part of my medical office building portfolio to make that happen. As I have said from the beginning, we need to learn a few things from this experiment. I am willing to complicate my life a bit in an effort to understand how things work.
Don’t say I didn’t give you fair warning, though. This write up is full of tax terms and numbers. You can handle it.
My Healthcare REIT Income
Between August and September of 2019, I purchased 435 shares of Physicians Realty Trust (DOC) in my taxable brokerage account.
The goal here was to generate about $100 in 2019 REIT dividend income for me to play with. DOC was generally paying a $0.23 per quarter dividend on each share. The plan was for this income to hit in the fourth quarter of 2019. Sure enough, in October of 2019 Physicians Realty Trust paid me $100 in dividends. Those dividends hit my brokerage account.
435 X $0.23 = $100
Let’s follow this $100 through my tax return. As we already know, the Max Out of Pocket crew lands solidly in the 22% tax bucket. This is my marginal tax bracket. I call these buckets, not brackets. In fact, I busted tax brackets awhile back. For every dollar I add to my 22% bucket, 22 cents goes to the taxman.
REITs usually throw off ordinary dividends that are not “qualified”. Qualified dividends get special tax treatment since they are taxed at the long-term capital gains rate of either 0%, 15%, or 20%. Nonqualified dividends, on the other hand, get taxed at the ordinary income tax rate. So the theory was adding nonqualified ordinary income to my 22% marginal tax bucket should cost me about 22 cents for each dollar of income my REIT generates. I was thinking it would look something like this.
$100 Nonqualified REIT Income X 22% Marginal Tax = $22.00 Tax
But I wanted to test this. Would the IRS really take $22 from my $100 in hard-earned REIT money? As it turns out, there are several other moving parts to this.
Ordinary Nonqualified Dividends
To my surprise, only 44% of this $100 in dividend income was considered ordinary nonqualified dividends. They are technically called “Section 199A” dividends but I am just going to call them nonqualified dividends from here on out. Apparently, companies like DOC release this information annually and it looks something like this.
44% X $100 REIT Income = $44.00 Ordinary Nonqualified Dividend
As I said above, I prefer dividends that are considered “qualified” dividends so we can pay the lower capital gains tax rate on them. That is one of the so-called drawbacks of REITs. Since this $44 in dividends is considered nonqualified, it hits the ordinary tax bucket just like all our other earned income does. In other words, it is taxed just like income I generate from my employer by trading my time for money. This is how it looked on my 1099-DIV tax form:
Most of the remaining part of the dividend was considered a non-dividend distribution. And just like that, we have a new term to learn.
The rest of my $100 dividend was a non-dividend distribution. This came out to about $56. I am going to cover this in more detail in part 2 of this post, but this portion technically didn’t even hit my 2019 income tax return and I was not taxed on it in 2019. I will need to worry about this in the future, but the take-home here is the $56 was not taxed in 2019. This concept blew me away. There is also a very small capital gain distribution that is completely immaterial on a $100 dividend so I won’t bother covering that today.
56% X $100 REIT Income = $56 Nondividend Distributions
So does this mean only the $44.00 in non-qualified ordinary dividends gets taxed at 22% in 2019? Yes and no.
To The Tax Return
So for tax purposes, this $44.00 in ordinary nonqualified dividends is all I needed to worry about in 2019. It landed on line 3b of my tax return (Ordinary Dividends). Since they are not “qualified” dividends, they are not reported on line 3a (Qualified Dividends). I realize I am being redundant, but I need to drive this concept home.
The $44.00 travels down the tax return to my total income on line 7b (total income) and eventually down to 8b (adjusted gross income). I assumed at this point, it would be taxed something like this.
$44.00 X 22% = $10 Tax
Wrong again, Max.
The Unexpected Qualified Business Income Deduction
Apparently, owning a healthcare REIT like DOC made me eligible for Qualified Business Income Deduction. This deduction is backed out of my income before the income tax is applied. It is a similar concept to the standard deduction. The calculation is pretty simple. For me, they took my total nonqualified REIT dividend income and multiplied it by 20%. It was easy for me, but there are a few other moving parts to this depending on the situation.
$44.00 X 20% = $9.00 Deduction
This $9.00 deduction lands on line 10 of my 1040 Tax Return. In theory, it reduces my $44.00 in non-qualified dividends by another $9.00 for tax purposes.
That leaves me with $35.00 in taxable income
$35.00 X 22% Marginal Tax Rate = $8.00 Tax
That tax on my $44.00 dividend is roughly 18%.
$8.00 / $44.00 = 18% Tax Rate
Evidently, humans like to make things complicated. This complexity probably keeps more than a few people employed. But at the end of the day, it’s good news for me. The IRS pulled $8.00 out of my pocket for income taxes on the $100 in dividends I received from DOC in 2019. We still have some homework to do on that $56 in non-dividend distribution. But so far I am feeling pretty good about this $8.00. This comes out to only 8% on the $100 I received. Perhaps I need to consider increasing my brokerage allocation.
$8.00 / $100 = 8% Tax
This is all thanks to the non-dividend distribution and the unexpected qualified business income deduction.
This $8.00 tax is pretty reasonable if you ask me. But what about those non-dividend distributions? Perhaps we have an opportunity to use a sabbatical or early retirement to time the release of the non-dividend distributions for tax purposes? More on that next time, here at Max Out of Pocket.
Interested in Part 2? Check it out here to see how those non-dividend distributions are handled here.
Max is not a CPA and this is not tax advice. It also isn’t a recommendation to buy REITs or any other investment. As always, you are responsible for your own investing decisions. That said, if a real-life accountant wants to validate any of my findings, please do so in the comments below.
Just like the IRS does, I lightly rounded the numbers above to the nearest dollar.