Diversification, recurring income, capital appreciation and inflation protection – just to name a few. These and more reasons are drawing more and more Americans to invest in REITs. A real estate investment trust or REIT is a company that owns, operates, or finances income-generating real estate. Established by US Congress in 1960, REITs are modeled after mutual funds in that they pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments (without having to buy, manage, or finance any properties themselves). Safe to say, REITs have opened doors for investment opportunities that for most would be out of reach. Still a little unsure? Here’s what you need to know about REITs.
What Qualifies as a REIT?
The REIT business model is pretty straightforward. REITs lease space and collect rent on the properties, then distribute that income as dividends to shareholders. Mortgage REITs don’t own real estate, but rather, finance real estate. These REITs earn income from the interest on their investments. To qualify as a REIT, a company must comply with certain IRS provisions and meet the following requirements:
- Be taxable as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders after the first year of existence
- Have no more than 50% of shares held by five or fewer individuals
- Invest at least 75% of total assets in real estate, cash, or US Treasuries
- Derive at least 75% of gross income from rents, interest on mortgages, or real estate sales
- Pay at least 90% of taxable income in the form of shareholder dividends each year
Properties within a REIT portfolio may include apartment complexes, restaurants, office buildings, hospitals, shopping malls, hotels, infrastructure (cell towers, energy pipelines, etc.) and warehouses. In general, REITs specialize in a specific real estate sector. However, diversified and specialty REITs may hold different types of properties in their portfolios, such as a REIT that consists of both office and retail properties. Many REITs are publicly traded under substantial volume on major exchanges, with investors buying and selling them like stocks throughout the trading session.
Three Types of REITs
There are three types of REITs you can invest in. The most common type is an equity REIT, which pays the highest dividends due to the rental income earned. When the real estate company sells a property, investors also make a prorated amount of the property’s capital gains or losses. Let’s break down the three types of REITs:
- Equity REITs – These trusts buy commercial properties and operate them. They collect rent and distribute profits to shareholders from the monthly rental income and capital gains.
- Mortgage REITs – These trusts invest in the debt used to buy investment properties. Their income comes from the interest earned on the mortgage payments.
- Hybrid REITs – These trusts invest in both equity and debt investments.
REITs are popular in part for the tax advantages they offer. Unlike most corporations, REITs don’t have to pay taxes at a corporate level, enabling them to reinvest more capital and make higher distributions to investors that aren’t subject to being taxed twice. Here are the top tax benefits investors can enjoy with REITs:
- The 90% Rule – REITs must pay out at least 90% of their profits as dividends to shareholders.
- Avoiding Double Taxation – REITs don’t pay corporate taxes, minimizing the risk of double taxation. Without corporate taxes owed, owners pay taxes only on the ‘pass-through’ income or the income they earn individually. After that, they pay taxes at their ordinary tax rate.
- Pass-Through Deduction – REIT investors can deduct up to 20% of the dividends paid from the REIT. This means REIT investors only pay taxes on 80% of the dividends earned.
- Depreciation – A tax deferral method making certain income earned from a REIT “return of capital” versus ordinary income. Ordinary income is taxed at an investor’s normal tax rate, whereas return of capital isn’t taxed because of depreciation.
- Qualified Business Income Deduction – Pass-through entity holders can deduct 20% of their income from REITs, allowing owners to pay federal taxes on just 80% of the dividends paid.
- Return of Capital Non-Taxable – Return of capital dividends are not taxed. They lower your tax basis and help you reduce your taxes on dividends paid and future dividends earned.
Short Term Rental Game Changers
Short term rentals (STRs) are the fastest-growing segment in hospitality, gaining market share for years. Factors like remote work opportunities, increased travel spending and consumer preference for experiences ensure the ever reaching popularity of STRs. Given this growth, vacation rental investing has become increasingly popular. Before REITs, the only way to break into the short-term rental market was to buy a home and rent it out. This of course requires the time and responsibility of driving occupancy, managing, and maintaining properties.
With the growth of the STR segment, comes an increased need for alternative ways, like REITs, to invest in rental homes. REITs have been around for decades as a way to fund real estate projects from residential to commercial. Commercial REITs, for example, pool investor assets to purchase real estate like hotels, office buildings and restaurants in exchange for a share of dividends and capital appreciation. REITs as a means of funding in the STR segment, however, are only a recent development.
While investing in public REITs is a great way to get exposure to real estate, investors aren’t limited to public companies. There are also private REITs to consider. Private and public REITs are similar in operation, but because private REITs are not traded publicly on a major stock exchange, they are less sensitive to volatility. They offer stability, historically strong returns, and of course the ability to invest in property without the hassle of management. Private REITs may be best suited to long-term investors who don’t seek immediate access to their invested capital. This lack of liquidity compared to public REITs also means private REITs are generally limited to accredited investors – those with high income or net worth.
We hope this article answered some of your questions about REITs. Do you have any experience in this field or have further questions or comments? Feel free to let us know in the thread below!