When it comes to investing, the beginner likely has heard of stocks and mutual funds, but there are a variety of other investment types that can make up a portfolio. In this “Investing 101” series, I’ll do my best to explain different investing opportunities as I understand them, and various things to know about each type of investment.
Today’s Investing 101: Real Estate Investment Trusts (REITs)
A REIT is a company that owns income-producing real estate. You can buy a REIT like a stock, but you’re really investing in property (or someone else’s mortgage.)
According to REIT.com, to qualify as a REIT a company must have most of its assets and income tied to real estate investment and distribute at least 90 percent of its taxable income to its shareholders annually. To qualify as a REIT, an entity must not be “closely held,” meaning, at any time during the last half of the taxable year, more than 50% in value of its outstanding stock cannot be owned, directly or indirectly, by or for not more than five individuals.
(Finance History Lesson – REITs were created by an act of Congress in 1960 to enable investors of all sizes to enjoy rental income from commercial property.)
Did you know? REITs generally fall into three categories: equity REITs, mortgage REITs, and hybrid REITs. There are five types of REITs — Retail REITs, Residential REITs, Healthcare REITs, Office REITs and Mortgage REITs. Retail REITs own — you guessed it — shopping malls and such. Residential REITs own apartment buildings. Healthcare REITs stock up on medical facilities like hospitals and retirement homes. Office REITs are in the business of office buildings. Mortgage REITs, such as Freddie Mac and Fannie Mae, buy mortgages instead of actual real estate.
REITs make their money from rents, interest on mortgages, gain from property sales, dividends from other REITs, abatements and refunds of taxes on property, income from foreclosure property, commitment fees, gain from the sale of property, and qualified temporary investment income (source: mofo.com)
Are REITs a good investment? Over the 30 years ended March 28, 2013, publicly traded equity REITs outperformed the leading stock market indexes, including the S&P 500, Dow Jones Industrials and NASDAQ Composite. (Source: FactSet, REITWatch.)
REITs are High Tax Investments
While REITs can be good investments due to their high yield, that yield is also not tax advantaged in the same way other investments would be. This is because dividend distributions for tax purposes are not Qualified Dividends and are allocated to ordinary income – i.e. *not capital gains tax rates.*
The tax situation on REITs is rather complicated, and I recommend you read REIT.com’s explaination here if you’re interested in the full details. While the IRS does not require the REIT itself to pay income taxes, most income from REITs is taxable at ordinary income rates to the shareholder. If invested in a taxable account, you would report non-qualified dividends on line 9a of IRS Form 1040.
This is a solid WSJ article on the tax issues of REITs, and what accounts to hold them in. The article notes that there are good reasons to place a traded REIT in an IRA. Matthew Senicola of JHS Capital Advisors, who is based in Plainview, N.Y., recommends placing traded REITs in an IRA because taxes on the dividends can be fully deferred. In a taxable account, by contrast, a large portion of the sizable dividends of REITs is treated as ordinary income, which generally subjects it to higher tax levels.
However, this Seeking Alpha article notes that even within tax advantaged accounts REITs can be liable for tax. The issue of holding REITs in IRAs is with UBTI — Unrelated Business Taxable Income. I’m still trying to figure out exactly what triggers this type of taxable income within an IRA… let me know if you understand this and I’ll update this paragraph with accurate information.
Do you hold any REITs in your portfolio? Am I missing any key points about REIT investing that I should share with my readers?