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, 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 examine the unique tax implications and savings they offer to regular investors.

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 a REIT represents a proportional fraction of ownership in each of the underlying properties. REITs on the NYSE possessed a market cap of $1.2 trillion as of January 2020. In 2020, 184 REITs were traded actively on the New York Stock Exchange. Typically, REITs tend to be more value-based 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 income to unitholders. This 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.

Three Types of REITs

REITs can be broken down into three categories:

  • 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 greater risk because of their exposure to interest rates. If interest rates rise, the value of mortgage REITs can drop substantially. 
  • Hybrid REITs - These instruments combine the first two categories. They can either be 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 Level

REITs must follow the same rules as all other unit investment trusts. REITs must be taxed first at the trust level, then to the 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:

  1. Rental income is treated as business income to REITs because the government considers rent to be the business of REITs. This means all expenses related to rental activities can be deducted in the same manner as business expenses can be written off by a corporation.
  2. Furthermore, current income distributed to unitholders is not taxed to the REIT, but if the income is distributed to a non-resident beneficiary, that income must be subject to a 30% withholding tax for ordinary dividends and a 21% (35% prior to Jan. 1, 2018) 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 unitholders. However, even REITs adhering to this rule still face corporate taxation on any retained income.

Taxation to Unitholders

The dividend payments made by the REIT are taxed to the unitholder as ordinary income unless they are considered 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 a REIT 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.

The Bottom Line

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.