Tax Treatment Of Preferred Stock Dividends

Most preferred stock investors hold shares issued by real estate companies. For the most part, how these companies earn their income throughout the year is irrelevant to us, except when we sit down to do our taxes. The tax treatment of our dividends received from real estate investment trusts (REITs) depends on how the company made its profits throughout the year.

The big attraction for a real estate company to become a REIT is that they do not have to pay taxes as long as they distribute at least 90% of their taxable earnings to shareholders (the IRS collects the taxes from the shareholders rather than from the company).

REITs commonly issue preferred stock and pay out dividends throughout the year in order to meet this requirement.

During normal economic times REITs earn their income from rents charged to tenants. But during an economic slowdown, the earnings of such companies throughout the year come not just from rents but also from capital gains as they sell off properties. And that changes how preferred stockholders are taxed on the dividends that we received throughout the year.

Remember that income received from regular rent is taxed differently than income received from selling a building. Profits from rents are regular income while profits received from selling off a building are capital gain income. The two types of income are taxed differently.

When the economy is booming, and REITs are building properties (not selling them), this issue rarely comes up. But during a slowdown (now), it is not unusual for preferred stock investors to see part of their dividend income classified as capital gain income since that is how the REIT earned it.

The good news is that capital gain tax rates are frequently more favorable than regular income tax rates. Plus, the work associated with figuring this out is done by the issuing company and your stock broker, not you.

During January, REITs tally up the portion of their earnings that came from rents versus the portion that came from capital gains for the just-ended year and notify your broker. Your broker consolidates this information for all of your REIT preferred stock holdings for you and reports the totals to you on your 1099-DIV form. These are the totals that you then plug into your tax return.


















This example is from First Industrial Realty for their Series J preferred stock (FR-J). Each quarter throughout 2010 holders of FR-J received a dividend of $0.453130 per share. You can see how First Industrial breaks down their earnings by type then, across the bottom, crosswalks the totals into the corresponding 1099-DIV form boxes.

The tax treatment of dividends received from REITs is based on how the REIT earned its profits throughout the year which is a bit different from other types of dividends that we receive. You can see First Industrial's 2010 declaration announcement here.

Many Happy Returns.