Why I Love Real Estate Investment Trusts (REITs): A Tax-Efficient Way to Invest in Real Estate
REITs are companies that own or finance income-producing real estate. They offer investors a way to gain exposure to the real estate market without having to purchase or manage individual properties. REITs are popular because of their:
- Income Streams: REITs are required to distribute at least 90% of their taxable income to shareholders, making them a source of regular income. This also means higher risk developers of real property are almost never structured as REIT’s.
- Significant Tax Advantages: REITs are taxed at a lower rate than traditional corporations, and their dividends are taxed as ordinary income at the shareholder level. This makes them a more tax-efficient investment than other real estate options.
The key tax advantage of REITs is their obligation to distribute at least 90% of taxable income to investors, often resulting in 100% distribution.
Most REIT dividends are taxed as ordinary income, with a maximum rate of 37% plus a 3.8% investment income surtax. However, the 2017 Tax Cuts and Jobs Act allows a 20% deduction on qualified REIT dividends, reducing the effective top tax rate to 29.6% until 2025.
REIT dividends consist of ordinary income, capital gains, and return of capital (ROC), each with distinct tax implications. Capital gains are taxed at 0%, 15%, or 20%, while ROC affects the investor’s cost basis and is taxed upon sale of the units. REITs can also offer reduced tax rates in certain scenarios, such as lower individual tax rates, capital gains distributions, or retained earnings.
REITs that provide good portfolio diversification theoretically are geographically dispersed across multiple asset classes without the need for multiple state income tax filings. They require minimal paperwork from investors, who only need to process a 1099-DIV form annually. Thus, REITs are a practical choice for those seeking the benefits of real estate investment with efficient tax handling and simplified administration.
Types of REITs:
There are three main types of REITs:
- Equity REITs: These REITs own and operate income-producing real estate, such as apartments, office buildings, and shopping malls.
- Mortgage REITs: These REITs provide financing for real estate projects.
- Hybrid REITs: These REITs combine the investment strategies of equity REITs and mortgage REITs.
Benefits of REITs:
- Tax Efficiency
- Diversification
- Passive Income, No Investor Management Obligations
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