Real estate investment trusts (REITs) have established themselves as a means for the smaller investor to directly participate in the higher returns generated by
real estate properties. In the past, these trusts were considered to be minor offshoots of
unit investment trusts, in the same category as energy or other sector-related trusts that had been created, but when the
Global Industry Classification Standard granted REITs the status of being a separate asset class the rules changed and their popularity soared.
In this article, we will explain how REITs work and then examine the unique tax implications and savings they offer to regular investors. (To begin with an overview of these assets and what they can do for your portfolio, see
The REIT Way.)
Basic Characteristics of REITs
REITs are a pool of properties and mortgages bundled together and offered as a
security in the form of unit investment trusts. Each unit in an REIT represents a proportionate fraction of ownership in each of the underlying properties. These investment vehicles constitute approximately 10% of the
financial sector and nearly one-quarter of the domestic
equity sector. In 2007, nearly 200 REITs were traded actively on the New York Stock Exchange and other markets.
Typically, REITs tend to be more
value than
growth-oriented, and are chiefly composed of small and mid cap holdings.
The IRS requires REITs to pay out at least 90% of their incomes to unitholders (the equivalent of shareholders). This is similar to corporations, and means REITs provide higher yields than those typically found in the traditional fixed-income markets. They also tend to be less volatile than traditional stocks because they swing with the real estate market. (To learn about REIT valuation, see
Basic Valuation Of A Real Estate Investment Trust.)
Three Types of REITs
REITs can be broken down into three categories: equity REITs, mortgage REITs and hybrid REITs.
- Equity REITs - These trusts own and/or rent properties and collect the rental income, dividends and capital gains from property sales. The triple source of income makes this type very popular.
- Mortgage REITs - These trusts carry a greater risk because of their exposure to interest rates. If interest rates rise, then the value of mortgage REITs can drop substantially. (To learn more, see The Impact Of Interest Rates On Real Estate Investment Trusts and Behind The Scenes Of Your Mortgage.)
- Hybrid REITs - These instruments combine the first two categories. They can be either open- or closed-ended (similar to open- and closed-ended mutual funds), have a finite or indefinite life and invest in either a single group of projects or multiple groups.
Taxation at the Trust LevelREITs must follow the same rules as all other unit investment trusts. This means that REITs must be taxed first at the trust level, then to beneficiaries. But they must follow the same method of self assessment as
corporations. So, REITs have the same valuation and accounting rules as corporations, but instead of
passing through profits, they pass
cash flow directly to unitholders.
There are a few extra rules for REITs beyond the rules for other unit investment trusts. They are:
- Rental income is treated as business income to REITs because the government considers rent to be the business of REITs. This means that all expenses related to rental activities can be deducted the same as business expenses can be written off by a corporation.
- Furthermore, current income that is distributed to unitholders is not taxed to the REIT, but if the income is distributed to a non-resident beneficiary, then that income must be subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains, unless the rate is lower by treaty.
For all practical purposes, REITs are generally exempt from taxation at the trust level as long they distribute at least 90% of their income to their unit holders. However, even REITs that adhere to this rule still face corporate taxation on any retained income.
Taxation to UnitholdersThe dividend payments made out by the REIT are taxed to the unitholder as ordinary income - unless they are considered to be "
qualified dividends", which are taxed as
capital gains. Otherwise, the dividend will be taxed at the unitholder's top marginal tax rate.
Also, a portion of the dividends paid by REITs may constitute a nontaxable
return of capital, which not only reduces the unit holder's
taxable income in the year the dividend is received, but also defers taxes on that portion until the capital asset is sold. These payments also reduce the
cost basis for the unitholder. The nontaxable portions are then taxed as either long- or short-term capital gains/losses.
Because REITs are seldom taxed at the trust level, they can offer relatively higher yields than stocks, whose issuers must pay taxes at the corporate level before computing dividend payout.
Example - Unitholder Tax Calculation
Jennifer decides to invest in an REIT that is currently trading at $20 per unit. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholders. However, $0.60 per unit of this dividend comes from depreciation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($1.80 - $0.60) of this dividend comes from actual earnings.
This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by $0.60 to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a long- or short-term gain/loss when the units are sold. |
Conclusion
The unique tax advantages offered by REITs can translate into superior yields for investors seeking higher returns with relative stability. Theoretically, it is possible for a unitholder to achieve a negative cost basis if the units are held for a long enough period of time. While this is hardly common, the potential for realizing a possible gain or loss in this manner should be clearly understood by investors.
by Mark P. Cussen (Contact Author | Biography)
Mark P. Cussen has over 13 years of experience in the financial industry, which includes working with investments, insurance, mortgages, taxes and financial planning. He has two years of experience in writing and editing insurance and securities test training manuals, as well as other financial topics. He has also worked in in retail, discount and bank brokerage systems and been involved in a venture capital enterprise in the oil and gas sector. Cussen has a Bachelor of Science in English from the University of Kansas and completed his CFP®; coursework at the Bloch School of Business at the University of Missouri-Kansas City in August of 2001.
