Real estate investment trusts, or REITs, are special purpose entities with special tax status, that own real estate and pass along most of the income from that real estate (rents or mortgage payments) to shareholders. They can own any type of real estate, and many specialize in one type, like apartment buildings, malls, office buildings, self-storage facilities or hotels.
A REIT that owns property directly and gets most of its income from its tenants’ rents is called an equity REIT.
A mortgage REIT, on the other hand, is a REIT that doesn’t own property directly. Instead, it owns property mortgages and mortgage-backed securities. Its income comes from the interest it’s paid on the mortgages. Mortgage REITs are sometimes called mREITs.
There are also hybrid REITs that own a mix of assets.
The Pros of REITs
Both types of REITs are exempt from taxation at the trust level as long as they pay out at least 90% of their income to investors. That means that while any retained income will be subject to regular corporate-rate taxes, the REIT doesn’t have to pay taxes on current income (rents or interest payments from the current period) that is distributed to unitholders (the trust version of shareholders).
Essentially, the REIT is treated as a “pass-through” entity, collecting the rents or interest payments and then passing them on to investors. It’s as if you own a sliver of the properties or mortgages themselves.
But that doesn’t mean REITs have zero growth potential. While they don’t retain much money to reinvest in their business, REITs often borrow money to make new acquisitions or improve properties. They can also earn more by raising rents or improving occupancy rates.
REIT performance tends to be more correlated to the real estate market than the overall stock market (and mortgage REITs are strongly affected by interest rates and credit conditions).
The Cons of REITs
REIT investing does have some tax consequences, however. Most of your REIT distributions will be classified as ordinary income because you are treated as a part-owner of the assets the REIT owns, and thus income from those assets is treated as your income. However, when some portion of a REIT’s distribution did not come directly from that quarter’s real estate ownership activities—for example, if it sold a building and distributed part of the proceeds to investors—you may be taxed differently on that portion of the distribution.
The REIT will tell you after year-end how that year’s dividends should be treated. Options include ordinary income, qualified dividend income, long-term capital gains and return of capital. Any portion of the distribution that is treated as return of capital will reduce your cost basis in the REIT, and then you’ll be taxed on the difference between your purchase price and your adjusted cost basis when you sell the REIT.
On average though, about 70% of REIT distributions are taxable as ordinary income.
This can be a good reason to own REITs in a tax-advantaged account like an IRA.
Whether you’re investing for retirement or looking to generate a steady flow of income now, REIT investing is a great way to do it.