Why REITs and BDCs pay such high dividends, and the tax catch

Scan a list of high-yield stocks and two kinds of company keep showing up: real estate investment trusts (REITs) and business development companies (BDCs). Their yields often sit well above the broad market’s. That isn’t because they are more generous than other companies. It’s because the tax code requires them to pay out most of what they earn, and that one rule explains both the high yields and most of the risks.

The rule behind the yield

A normal company pays corporate income tax on its profits, then decides how much of what’s left to pay as dividends. Many keep most of it to reinvest in the business.

REITs and BDCs work differently. If they meet a set of tests in the tax code, they can deduct the dividends they pay, which means they pay little or no corporate income tax. The price of that deal is a payout requirement: each year they must distribute at least 90% of their taxable income to shareholders. For REITs the rule is in Section 857 of the Internal Revenue Code; BDCs qualify under the rules for regulated investment companies in Section 852, the same ones that apply to mutual funds.

So the income flows straight through to you instead of being taxed at the company level first. That is the source of the high yield.

What they actually own

REITs own or finance real estate: apartment buildings, warehouses, shopping centers, office towers, cell towers, data centers, hospitals. Most collect rent. A smaller group, mortgage REITs, hold mortgages and mortgage-backed securities and earn interest instead.

BDCs were created by Congress in 1980 to channel money to smaller private companies. Most of what they do today is lending to mid-sized private businesses, often companies owned by private equity firms. Their income is mostly the interest on those loans.

What the payout rule means for the business

Paying out 90% or more of taxable income leaves very little to reinvest. When a REIT wants to buy more buildings, or a BDC wants to make more loans, it usually has to raise new money by selling more shares or borrowing. That has three consequences worth knowing.

• Share counts tend to grow. New shares spread the company’s income across more owners. Growth in dividends per share, not total dividends, is the number to watch.
• Borrowing costs matter a lot. These companies depend on access to debt and equity markets. When rates rise or markets tighten, growth gets harder and more expensive.
• Dividends can be cut. A required payout is a percentage of income, not a fixed amount. If income falls, the dividend usually follows.

Reading the payout ratio correctly

A REIT’s reported earnings per share is often smaller than its dividend, which makes the payout ratio look above 100%. Much of that gap is depreciation, an accounting charge for the wear on buildings that doesn’t use up cash in the year it is recorded. That is why REITs report funds from operations (FFO), which adds real estate depreciation back. A payout ratio based on FFO tells you more than one based on earnings per share.

For BDCs, the useful comparison is the dividend against net investment income, the interest and fees they earn minus expenses. A BDC paying out more than its net investment income for several quarters in a row is spending something other than its earnings. The Payout Ratio Calculator works with either figure: enter FFO or net investment income per share in place of earnings per share.

The risks behind the yield

• Leverage. Both use borrowed money. Since 2018, BDCs have been allowed to borrow up to two dollars for every dollar of equity, up from one, if they meet certain approval and disclosure conditions.
• Interest rates. Many BDC loans have floating rates, so their income tends to rise when rates rise and fall when rates fall. REITs feel rates through their borrowing costs and through property values.
• Credit. BDC borrowers are smaller, often heavily indebted companies. Losses on a few loans can cut net investment income quickly.
• The property cycle. Rents, occupancy and property values move with the economy and with the type of building. Office, retail and warehouse REITs can have very different years.

One more: some REITs and BDCs are not traded on an exchange. Non-traded versions can be hard to sell, often charge high upfront fees, and may pay distributions that partly come from investors’ own money. The SEC’s investor site has a bulletin on non-traded REITs that is worth reading before you buy one.

How the dividends are taxed

Because REITs and BDCs mostly don’t pay corporate income tax, most of their dividends are not “qualified” dividends. They are taxed as ordinary income at your regular tax rate, not at the lower 0%, 15% or 20% rates that apply to qualified dividends from most other US companies. Your Form 1099-DIV splits it out.

REIT investors get a partial break. Ordinary REIT dividends (box 5 of the 1099-DIV, “Section 199A dividends”) qualify for a 20% deduction, so only 80% of that income is taxed at your bracket rate. The 2025 tax law made this deduction permanent; it had been due to expire after 2025. BDC dividends generally don’t get this deduction.

Federal income tax on $1,000 of dividends, by tax bracket:

The qualified column assumes the 15% rate, which covers most people in these brackets. The table leaves out state tax and the 3.8% net investment income tax, which applies above certain incomes to all three kinds of dividend.

Two other boxes on the 1099-DIV can show up for these companies. Capital gain distributions (box 2a) are taxed at long-term capital gains rates. Nondividend distributions (box 3), often called return of capital, aren’t taxed when you receive them; they lower your cost basis instead, which means a larger gain, and more tax, when you sell.

Because so much of the income is taxed at ordinary rates, many investors prefer to hold REITs and BDCs in IRAs and other tax-advantaged accounts, where the dividends aren’t taxed each year. To see the effect on your own numbers, enter the amount as non-qualified dividends in the Dividend Tax Calculator.

The short version

REITs and BDCs yield more because the law makes them pass most of their income through to shareholders. That gives you more income now, less growth from retained earnings, more dependence on borrowing and capital markets, and dividends that are mostly taxed at ordinary rates. Judge them on whether their FFO or net investment income covers the dividend, not on the yield alone.

Sources

• 26 U.S. Code § 857: taxation of REITs and their beneficiaries
• 26 U.S. Code § 852: taxation of regulated investment companies
• 26 U.S. Code § 199A: qualified business income, including qualified REIT dividends
• IRS: About Form 1099-DIV
• Investor.gov (SEC): Investor Bulletin on non-traded REITs