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According to investopedia, a REIT is similar to a mutual fund, in that they pool capital to invest in real estate. But as far as I know, REITS do have an IPO, and traded like a stock. My question: is REIT's outstanding shares generally a fixed number or not? If yes, it's more like a stock.

Besides, in this article: Investopedia- The basics of REIT taxation, they say:

While a steady flow of payments may sound enticing, REIT dividends come with unique tax consequences for investors. These payments can constitute ordinary income, capital gains, or a return of capital.

And, they give an example:

An investor buys a REIT currently trading at $20 per unit. The REIT generates $2 per unit from operations and distributes 90% (or $1.80) to unitholders. Of this, $1.20 of the dividend comes from earnings. The remaining $0.60 comes from depreciation and other expenses and is considered a nontaxable return of capital.

The investor would pay ordinary income taxes on the $1.20 in the year in which it was received. Meanwhile, the investor's cost basis is reduced by $0.60 to $19.40 per share. As stated previously, this reduction in basis will be taxed as a either long- or short-term gain or loss when the units are sold.

Based on what the author says, the return of capital lowers the cost basis; hence increase the gain. As far as I know, this increased gain is only on paper, meaning the investor has to pay more tax, whereas he actually realized a smaller gain. Isn't that a bad thing for the investor?

Partnership ETFs, as well, make distributions in the form of return of capital, which cause adjustments to cost basis; and they issue schedule K-1's. So, do REITs also issue a schedule K-1, or are dividends and Profits/Losses from selling the shares only reported on 1099's ?

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A REIT files its federal income taxes on Form 1120-REIT. This is a customized version of the Form 1120 filed by C-corporations, but is fundamentally a pass through entity simplified because it has so many shareholders.

At the end of each calendar year, shareholders will receive forms 1099-DIV and 8937 (Report of Organizational Actions Affecting Basis of Securities). In the case of a REIT, these two forms combined are functionally equivalent to Schedule K-1.

Functionally, it is closer to a partnership (which files Form 1065) or S-corporation (which files Form 1120-S), because the ordinary income, capital gains, return of capital, basis adjustments, exempt interest, and foreign tax credit components of the entity are allocated to shareholders in proportion to their dividends to the extent that the dividends paid are sufficient (and REITs basically have to pay 90% of their income in dividends each year). Like other pass through entities, it gets the 20% passthrough income deduction established in the 2017 tax law.

The way that a REIT passes through distinct components of its income and losses and tax characteristics to the extent that dividends are paid, and is taxed at the entity level to the extent that dividends are not paid is closely analogous to, and more similar to than a partnership or S-corporation, the taxation of a complex trust, even though it does not file taxes on Form 1041 as a complex trust does and does not issue Schedule K-1 to beneficiaries the way that a complex trust does. (A complex trust is a trust with more than one beneficiary with a trustee who can choose how much of its income and principal to distribute to the beneficiary in any given year on a discretionary basis.)

At any given time, REITs have a certain number of shares outstanding, much like stock in an ordinary publicly held corporation (and unlike a typical complex trust). But, like a corporation (and again unlike a typical complex trust) a REIT can, in principle at least, redeem shares and issue shares, so while the number of shares at any one time is fixed, the number of shares could vary from time to time.

For example, even though there is an IPO, that doesn't necessary mean that all shares offered publicly will be sold at precisely the same time. In a December offering, some shares might be sold in December, some might be sold in January of the following year, and some shares might be sold after that.

Most REITs are organized at a state law level as business trusts, but they can also be organized at a state law level as a corporation or as another type of association. REIT tax classification largely disregards the nature of the entity under state law.

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  • Thanks, but I still can't understand why the article says: "When the REIT's cash distributions exceed earnings( such as, caused by large depreciation expenses) can result in a portion of the dividend is listed as nontaxable return of capital " - (dividends means profit for investors) . Furthermore, those returns of capital seem to cause unfavorable tax consequences for investors. – domino Feb 24 at 21:56
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    @domino Suppose that the REIT has $50M of income before depreciation, $30M of depreciation, and $20M of net profits, but distributes $45M to shareholders, with you getting $4,500 of distributions. The ordinary dividend income from the $4,500 distribution to you is $2,000. The remaining $2,500 is a return of capital which is tax free at the time of distribution but will give rise to an additional $2,500 when your shares are sold (which is deferred in time from when you got the money, and may be at a lower tax rate, depending upon who long you've held the shares at the time of the distribution). – ohwilleke Feb 24 at 22:15
  • So, in that year, the REIT lost $25M, and that loss will be allocated to shareholders? ( on what form ?). And, does the investor really see the $2500; or just have to pay the additional tax on $2500( that is not really received), to balance out the $2500 allocated loss which will be deducted from the investor's gross income ? – domino Feb 25 at 7:20
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A REIT is like a closed-end fund, not like a mutual fund. You buy/sell a mutual fund at net asset value (NAV) at the end of each trading day. REITs and CEFs are traded during the trading day and can trade at a premium/discount of their NAV.

Here is a chart showing the average premium/discount to NAV, for REITs over the last 30 years.

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