Real estate investment trust (REITs) are required to distribute at least 90% of their income to shareholders making it a high income investment. In exchange for this, REITs do not pay corporate income taxes like other corporations. REIT dividends are therefore taxed to the individual shareholder. The taxes are treated as either capital gains, ordinary income or capital return depending on how many properties were sold that year or how much depreciation was incurred.
A REIT dividend may be due to the sale of an asset which is recorded as a capital gain. It would be taxed at the long-term capital gains rate (assuming the asset was held longer than a year) at the rate coinciding with the investor’s income level. This is similar to a private real estate investor selling an investment property & paying capital gains on that sale.
Dividends that are categorized as “return of capital” are not taxed. REITs are able to characterize a large portion of their dividends as return of capital (vs. ordinary income) thanks to depreciation. This is a huge benefit for long term holders (evergreen investments) as you can deferred these taxes indefinitely by maintaining ownership. The ability to compound returns by deferring taxes is a huge advantage and a compelling feature of REITs (both public and private).
Finally, the Tax Cuts & Jobs Act of 2017 contained a provision that created a tax break for qualifying “pass-through income.” REIT dividends are covered under this provision & investors can receive a 20% break on that income.