Complete Guide To Investment Companies, Funds And REITs

AAA

Real Estate Investment Trusts (REITs) - Taxes

Taxes
To qualify as a REIT with the IRS, a real estate company must agree to pay out at least 90% of its taxable profit in dividends (and fulfill additional but less important requirements). By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on its entire profit and then decides how to allocate its after-tax profits between dividends and reinvestment; a REIT simply distributes all or almost all of its profits and gets to skip the taxation.

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.

REITs 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:

  1. 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.
  2. 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.

The 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, 60 cents 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 - 60 cents) of this dividend comes from actual earnings.

This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by 60 cents 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.

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.

Investing In REITs


Related Articles
  1. Taxes

    The Basics Of REIT Taxation

    The unique tax advantages offered by these investments can translate into superior yields.
  2. Investing Basics

    The Basics of Reinvesting REIT Dividends

    Learn the essentials of dividend reinvestment in real estate investment trusts and how a dividend reinvestment plan can magnify your long-term returns.
  3. Options & Futures

    20 Investments: Real Estate Investment Trusts (REITs)

    What Is It? What if you want to invest in the real estate sector, but you either already have a house or don't have enough money to buy one right now? The answer is REITs. REITs sell like stocks ...
  4. Bonds & Fixed Income

    Are REITs Beneficial During A High-Interest Era?

    Amid expectations of high interest rates, do REITs offer a viable investment option? Investoepdia studies the historical data to decide.
  5. Mutual Funds & ETFs

    REITs vs. REIT ETFs: How They Compare

    Learn about the difference in investing in a REIT for a single real estate company versus investing in a REIT ETF that tracks a larger REIT index.
  6. Products and Investments

    REITs: Still a Viable Investment?

    Are REITs viable investments now? Here's a look at the history of REITs' performance during rocky economic times and other factors that may impact returns.
  7. Investing

    REITs 101: How They're Regulated

    Here's everything you need to know about REITs in less than five minutes.
  8. Stock Analysis

    Why REITs Remain A Great Place To Put Your Money

    REITs have been a good investment over the long haul. Here's Why.
  9. Investing

    What Is a REIT and Does It Belong in My Portfolio?

    Real estate investment trusts offer a unique way for investors to own a real estate portfolio without the risks of owning single properties.
  10. Investing Basics

    5 Types of REITs And How To Invest In Them

    Real estate investment trusts are historically one of the best-performing asset classes around. There are many types of REITs available.
RELATED TERMS
  1. REIT ETF

    Exchange-traded funds that invest the majority of assets in equity ...
  2. Unitholder

    An investor who owns one or more units in an investment trust. ...
  3. Funds From Operations Per Share ...

    A metric for the performance of a real estate investment trust ...
  4. Non-Traded REIT

    A form of real estate investment method that is designed to reduce ...
  5. Finite-Life REIT - FREIT

    A real estate investment trust (REIT) that aims to sell its real ...
  6. Cash Distribution Per Unit - CDPU

    A measure, used in Canada, that refers to the amount of cash ...
RELATED FAQS
  1. Which REITs pay the highest dividends?

    Find out more about real estate investment trusts and which ones have dividend yields greater than 15% for the year 2015. Read Answer >>
  2. What is the difference between an Equity REIT and a Mortgage REIT?

    Find out more about real estate investment trusts and the main differences between equity and mortgage real estate investment ... Read Answer >>
  3. Is a REIT a type of ETF?

    Learn the differences between real estate investment trusts, or REITs, and exchange-traded funds, or ETFs, to see how the ... Read Answer >>
  4. What is the difference between adjusted and regular funds from operations?

    Understand a REIT's regular funds from operations and its adjusted funds from operations. Learn what each is used to measure ... Read Answer >>
  5. What are the most popular ETFs that track the real estate sector?

    Learn the fundamental information about some of the most popular and best-performing ETFs that investors use to access the ... Read Answer >>
  6. Is investing in a REIT a conservative investment or is it aggressive as far as preservation ...

Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center