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December 18, 2023 | read

Fundamentals of Investing in Real Estate Investment Trusts (REITs)

Ben Isley

REITs offer average investors exposure to income-generating and diversified real estate deals. Many investors who focus heavily on the stock market now add some stability with real estate trusts that generally come with less risk and a nice dividend payout.

In this article, I’m focusing on publicly traded REITs. The information below doesn’t necessarily apply across the board to similar investment vehicles such as private REITs, Real Estate Investment Groups (REIGs), or mortgage REITs (mREITs).

History and Overview

As an investment vehicle, REITs offer individual investors access to larger groupings of real estate that are otherwise unavailable or inaccessible to average people. Traditionally there are elusive requirements to partake in large-scale real estate investment such as funds of residential homes or commercial real estate deals. Generally, large real estate deals involve huge amounts of capital upfront, sometimes accreditation is required, and a deep and trusting network of the entire team is required to make the deal happen. Historically, a very high net worth is required to even sniff these deals.

REITs offer average investors exposure to income-generating and diversified real estate deals. Many investors who focus heavily on the stock market now add some stability with real estate investment trusts that generally come with less risk and a nice dividend payout. The dividend payout is generally higher because REITs are sheltered from tax at the corporate level, as opposed to most corporations, which must pay tax on their income before issuing dividends. REITs are essentially passing the cash flow from the assets directly to investors. A share of a REIT is a fraction of the ownership of all of the properties held by the REIT.

Check out our podcast episode 97 with Matt Argersinger from The Motley Fool

Since their creation in 1960s, REITs have continually been subject to legislation that has provided increased accessibility, such as the ability to establish as corporations or business trusts and the ability to be included in pension plans and retirement accounts. Legislation on the topic has also enabled REITs to buy and sell property more efficiently.

REITs have also grown in breadth in regards to foreign availability and different classifications of REITs. Instead of only including commercial real estate, REITs now include single family homes, self-storage, office, industrial, health care, lodging, and even timberland – or any combination.

Examples

  • VNQbenchmark REIT
  • O – diverse but heavily commercial
  • STOR – single-family residential real estate
  • STAG – industrial real estate 
  • DLR – data centers, networks, cloud and digital storage properties
  • REET – global real estate

 

Publicly Traded REITs vs. Residential Real Estate – Broad and Simplified Comparison

  Liquidity Diversification Barrier to Entry Control Taxes
REITs High High Low None High burden
Residential RE Low Low High Full Comparatively lower

 

Requirements of Publicly Traded REITs

  • Must pay out 90% of taxable income as dividends to shareholders
  • Management is a board of directors or trustees
  • Taxable as a corporation
  • Invest minimum 75% of total assets in real estate, cash, or treasury bonds
  • Derive minimum 75% of gross income from rental income, real estate sales, and interest on mortgages that finance real property
  • No more than 50% of shares held by 5 or fewer individuals
  • Have a minimum of 100 shareholders

 

Taxation of REITs

The majority of dividends paid to shareholders from REITs is from the taxable income (operating profit) portion of the gross income. Payment of the dividends passes the tax burden on to the investor. This is considered ordinary income and is taxed at the shareholders marginal tax rate as non-qualified dividends.

When the management of the REIT sells an asset for a profit, capital gains tax comes into play. Dividends received from this activity are considered qualified dividends.

Duration of holding of the individual asset < 1 year = short term capital gains

Duration of holding of the individual asset > 1 year = long term capital gains

REIT Management makes this information available and passes it on to the investors through forms 1099-DIV (required by IRS to report dividends and other distributions to taxpayers) and 8937 (required by IRS to report organizational actions, including nontaxable distributions).

There is also a pass-through deduction available for REITs. This deduction allows REIT shareholders to deduct up to 20% of their dividends.

Eliminate the exposure to and complexity of REIT taxation by holding them in a tax-advantaged retirement account such as a Roth IRA!

Check out https://www.reit.com/ for much more info on these investment vehicles

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