Real estate is an asset class that offers protection against inflation, as well as potential tax benefits. However, lack of both liquidity and diversification are drawbacks to investing directly in real estate.


Real Estate Investment Trusts (REITs).
REITs work much like closed-end mutual funds, but instead of owning a portfolio of securities, the REIT owns a portfolio of real estate properties and/or mortgages.

REITs are registered securities under the SEC and trade in the secondary market, like stocks. As a result, investors get the benefit of diversification (since most REITs own a large number of properties) and liquidity.

Unlike mutual funds, REITs are permitted to use leverage - the income from the properties within the REIT is then used to pay the costs of any loans involved.

There are two main types of REITs:

  • Equity REITs - these invest mainly in actual real estate properties, such as office buildings, apartment complexes, warehouses and shopping centers. Equity REITs are usually not highly leveraged.

  • Mortgage REITs - these invest mainly in mortgages and construction loans for commercial properties and tend to use leverage to a greater degree than equity REITs.

The following series of articles contain valuable information about REITs, such as how to analyze them, advantages and disadvantages, how to pick the right REIT and more:

REIT Taxation
Similar to mutual funds, REITs may qualify for conduit taxation on distributed net income. To qualify, an REIT must obtain at least 75% of its income from real estate-related activities and must distribute at least 90% of investment income to shareholders. There is no minimum distribution requirement for capital gains, but the REIT must pay taxes on the capital gains if they are retained rather than distributed.

Look Out!
REIT taxation is similar to that of mutual funds, but not identical. Note that mutual funds must distribute 97% of net income and 98% of capital gains, while the REIT requirements are much lower.


Real Estate Limited Partnerships
These real estate investments are set up with a general partner, who manages the properties and makes investment decisions, and a number of passive "limited partners", who simply enjoy the income and tax benefits of the real estate within the partnership.

Since partnerships are not taxable entities, each limited partner claims a pro-rated portion of income or losses on his/her own personal return. As a result, most real estate limited partnerships are created as tax shelters, so investors get the benefits of:

  • Depreciation deduction - on a straight-line basis over a life of 27 and a half years
  • Mortgage interest deduction - if property is leveraged
  • Long-term capital gains - when property is sold


Exam Tips and Tricks
Consider this sample exam question about REITs:

  1. The following statements about REITs are all true, EXCEPT:
    1. They can be traded on the NYSE.
    2. 75% of their assets must be invested in real estate.
    3. 75% of their gross income must be from real estate-related investments.
    4. 90% of their net investment income must be distributed to shareholders to qualify for conduit tax treatment.

The correct answer is "B". REITs have no requirement for the percentage of assets invested.



Variable Annuities

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