What Are the Disadvantages of REITs? A Guide for High-Income Families in California and Washington

By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.

The main disadvantages of REITs are heavy taxes on their dividends, sensitivity to interest rates, limited ability to grow from retained earnings, stock-market-level volatility, and, for non-traded REITs, high upfront fees and money you cannot easily get back. For a high-income family in California or Washington, the tax point usually matters most: most REIT dividends are taxed as ordinary income, not at the lower qualified-dividend rate, so where you hold a REIT fund can matter as much as whether you hold one.

This article is written for W-2 households earning roughly $750,000 to $3 million, often with RSUs, a mega backdoor Roth option and a California or Seattle-area home that is already their largest real estate holding. It covers each drawback, a worked tax example at that income level, and the questions to settle before adding REITs to a family portfolio.

What a REIT is, in one paragraph

A real estate investment trust is a company that owns or finances income-producing property such as apartments, warehouses, data centers or medical buildings. To qualify, it must distribute at least 90 percent of its taxable income to shareholders each year as dividends, and in return it can deduct those dividends and usually owes no corporate tax (SEC investor bulletin on REITs). Most families own REITs through a listed REIT index fund or ETF, and many already own some through a total-market index fund without realizing it.

Disadvantage 1: REIT dividends are taxed at ordinary rates

The SEC’s bulletin puts it plainly: dividends paid by REITs “generally are treated as ordinary income and are not entitled to the reduced tax rates on other types of corporate dividends.” For a household in the 37% federal bracket (for 2026, married filing jointly, taxable income over $768,700 per Rev. Proc. 2025-32), that is a large gap compared with the 20% top rate on qualified dividends and long-term gains.

There is a partial offset. Qualified REIT dividends (reported in box 5 of Form 1099-DIV) get a 20% deduction under Section 199A, and the IRS states that this part of the deduction “is not limited by W-2 wages” (IRS, Qualified Business Income Deduction). Unlike the business-income part of 199A, it does not phase out at high incomes. The One Big Beautiful Bill Act removed the deduction’s scheduled end date for tax years after 2025 (P.L. 119-21, section 70105). With the deduction, the top federal rate on qualified REIT dividends works out to 29.6% (37% on 80% of the dividend), before the 3.8% Net Investment Income Tax, which applies once modified AGI is over $250,000 for joint filers (IRS, NIIT).

California versus Washington

• California taxes all investment income at ordinary rates, with no lower rate for capital gains (FTB), and it does not follow the federal Section 199A deduction (FTB K-1 instructions). REIT dividends are taxed in full at your marginal rate: 11.3% for joint taxable income between $891,542 and $1,485,906, and 12.3% above that, for 2025 (the latest published schedules), plus the 1% Behavioral Health Services Tax on taxable income over $1,000,000.
• Washington has no individual income tax for 2026, so REIT dividends carry federal tax only (WA DOR). Two caveats for this income level: a new 9.9% income tax on AGI over $1,000,000 takes effect January 1, 2028, and Washington’s capital gains tax (7% on long-term gains above an annual standard deduction of $278,000 for 2025, the latest published amount, rising to 9.9% on taxable gains above $1,000,000) may reach gains when REIT fund shares are sold from a taxable account (WA DOR capital gains tax).

Worked example: $12,000 of REIT dividends at a $1.2 million income

Assumptions (illustrative): a married couple filing jointly, $1.2 million of W-2 income, federal taxable income over $768,700, California taxable income of about $1.15 million. They hold $300,000 in a REIT index fund in a taxable brokerage account, and we assume a 4% yield, all of it qualified REIT dividends. The comparison is the same $12,000 received as qualified dividends from a broad stock fund. California figures use 2025 schedules.

The REIT fund costs this family about $1,152 more in tax each year on the same income, or roughly $11,500 over ten years before growth. For this family in California, close to half of every REIT dividend goes to tax when the fund is held in a taxable account.

Now hold the same $300,000 of REIT exposure inside a Roth account instead, for example one funded through a mega backdoor Roth in a 401(k). The dividends are reinvested with no current tax, and qualified withdrawals are tax-free. In a traditional 401(k) or IRA, tax is deferred and the eventual withdrawals are taxed as ordinary income anyway, so the REIT’s ordinary-income character costs nothing extra there. This is why the SEC notes that “some investors prefer to own shares of a REIT or REIT fund inside a tax-deferred account.”

Not every REIT payout is an ordinary dividend. Part may be reported as a capital gain distribution or a nondividend distribution (return of capital), which lowers your cost basis instead of being taxed now (Form 1099-DIV instructions). The mix changes each year, so the example above is the high-tax case.

Disadvantage 2: Interest rates move REIT prices

REITs borrow to buy and develop property, and many investors hold them for income. When rates rise, borrowing costs go up and bonds and cash offer competing yields, so REIT share prices often fall. When rates fall, the reverse can happen. A family that buys REITs as a “safe income” holding can see drawdowns that look more like stocks than bonds. If the goal is stable money for a house down payment or private school tuition in two years, a REIT fund is usually a poor fit for it. Our comparison of high-yield savings versus a brokerage account covers where short-term money belongs.

Disadvantage 3: The 90% payout limits internal growth

Because a REIT must pay out at least 90% of its taxable income, it keeps little cash to reinvest. To buy new property it usually issues new shares or takes on debt. New shares can dilute existing owners, and more debt adds to the interest-rate risk above. An ordinary company can reinvest its earnings and let the share price grow, which is also more tax-efficient for a taxable investor who can choose when to sell.

Disadvantage 4: Volatility and sector risk

Listed REITs trade on stock exchanges and fall with the stock market in a sell-off. They also carry property-type risk: office, retail, hotel and apartment REITs can move very differently depending on remote work, consumer spending and local supply. A single-sector or single-company REIT position adds concentration that a broad fund avoids.

Disadvantage 5: Your home is already a large real estate bet

For a family with a $2 million to $4 million house in the Bay Area, Los Angeles or the Seattle area, real estate is often already the biggest line on the balance sheet. Adding a REIT fund on top of that may increase, rather than diversify, the family’s exposure to property values and interest rates. A total US stock market index fund already includes listed REITs at their market weight, so many families hold some real estate exposure without a separate fund. Look at the whole balance sheet before adding more; our note on family office asset allocation walks through that view.

Disadvantage 6: Non-traded REITs are illiquid and expensive

Non-traded REITs are the version most often pitched to high-income families, usually with an attractive stated distribution rate. The SEC lists the problems:

• High upfront fees. Sales commissions and offering fees of “approximately nine to 10 percent,” so a $250,000 purchase may put only about $225,000 to $227,500 to work.
• Lack of liquidity. They “generally cannot be sold readily on the open market,” and the timing of any exit is up to the company.
• No real-time share price. There is no market price, so the value you see is an estimate.
• Distributions may be paid from offering proceeds and borrowings, which means part of the “yield” can be your own money coming back.

Before signing, ask for the total fee load in dollars and the redemption terms in writing. Our guide on how much to pay in investment fees shows how to compare them.

Disadvantage 7: Losses do not pass through to you

A REIT is a corporation, not a partnership, so it “cannot pass any tax losses through to its investors” (SEC). Direct ownership of a rental property can generate depreciation deductions, although at this income level passive loss rules usually limit their use against W-2 pay. With a REIT, you get none of that; you receive dividends and pay tax on them.

What REITs still do well

For balance, the advantages are real: daily liquidity for listed REITs, professional management, access to property types a family could never own directly (data centers, cell towers, logistics), and low costs through index funds. For most families at this income level, the question is less “REITs, yes or no” and more “how much, and in which account.”

Decision checklist before adding REITs

1. Do we already hold REITs through a total-market fund, and at what weight?
2. How much of our net worth is already our home and any rental property?
3. Do we have room in a Roth, traditional 401(k) or IRA to hold a REIT fund instead of a taxable account?
4. Is this a listed index fund, or a non-traded REIT with upfront fees and limited redemptions?
5. Is any of this money needed within five years?
6. For Washington families: how does the 2028 income tax change the picture if our AGI is over $1,000,000?

If the answers point to “yes, a small allocation,” the usual order is a low-cost listed REIT index fund in a tax-advantaged account first. More on how we think about portfolio risk is on our investment risk management page, and on account placement on our tax management page.

What to write down for your kids

Your children will see which funds are in the accounts. They will not see why. A short note, “We hold REITs only in the Roth because their dividends are taxed like wages; we avoided the non-traded REIT pitch in 2026 because of the 9 to 10% upfront fees and the lock-up,” teaches more about taxes, fees and patience than the holding itself. Conversations fade. Documentation compounds. That kind of note is what the FamilyKnowledge® Library is built to capture.

Frequently asked questions

Are REITs a bad investment for high earners?

Not necessarily. The main drawback for high earners is tax: in a taxable account in California, a large share of each REIT dividend goes to federal and state tax. Held inside a Roth or traditional retirement account, that drawback largely disappears. The bigger risks are overlap with a home you already own and the fees and illiquidity of non-traded REITs.

Do REIT dividends qualify for the 20% qualified dividend rate?

Generally no. Most REIT dividends are taxed as ordinary income. Federally, qualified REIT dividends get a 20% Section 199A deduction that does not phase out at high incomes, which brings the top federal rate to 29.6% plus the 3.8% NIIT. California does not allow that deduction, so the full dividend is taxed at your California rate.

Should I put REITs in my Roth or my traditional 401(k)?

Either shelters the dividends from current tax. A Roth, including one funded by a mega backdoor Roth, lets future growth come out tax-free, so many families place their highest-growth or least tax-efficient holdings there. The right split depends on your other holdings and expected future tax rates, which is a whole-portfolio decision.

This is general education, and the right move depends on the family’s full picture. If you would like a second look at how your accounts are placed, the Tax & Wealth Assessment is where we start.

Written by

Kevin Luu

Co-Founder and Chief Learning Officer, Bright Advisers

Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.

Connect on LinkedIn →  · About Kevin