REITs are some of the most popular investments on Seeking Alpha. Yet, they are also some of the most misunderstood.
If you are new to REITs, you need to start by gaining an understanding of their history and purpose.
REITs can be fantastic investments, but nothing is perfect. We highlight the main advantages and disadvantages that you need to know before investing.
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porcorex/E+ via Getty Images Introduction: REITs 101
Real estate investment trusts, or “REITs,” ( VNQ ) are a marvelous invention that has effectively democratized commercial real estate investment.
In 1960, the United States Congress passed a bill, signed into law by President Eisenhower, that established the REIT structure, creating a way for even small-dollar investors to own pieces of real estate portfolios through tradable securities. The US was a trailblazer in this regard, as dozens of other countries instituted similar models in the decades after REITs were created in the US.
REITs, which can own the equity in real estate assets or invest in real estate through loans, combine attributes of stock market investing with real estate investing.
In 1986, Congress passed the Tax Reform Act, which gave REITs the ability not only to own or loan to real estate assets, but also the ability to operate and manage them. This opened the door, for example, for hotel and self-storage REITs to not only own their real estate but also to run the operations. The types of assets classifiable as “real estate” for the purposes of becoming a REIT continue to expand. Over the last ten years, oil & gas pipelines, farmland ( FPI ; LAND ), billboards ( LAMR ; OUT ), telecommunications fiber ( AMT ; CCI ; SBAC ), and post offices ( PSTL ) have all been officially sanctioned as assets eligible to be held by REITs. Today, REITs own 516,000 real estate properties worth around $2.5 trillion across the United States, according to NAREIT.
In this article, let’s go back to the REIT basics to understand the crucial, but often overlooked tax implications for this type of stock. Then we’ll explain some advantages and disadvantages of public REITs as an investment vehicle.
While this is intended as a more basic article to help newer REIT investors understand the model, hopefully even seasoned REIT investors can get some nuggets out of it as well. The Tax Basics of REITs
REITs are tax structures sometimes called “pass-through companies” that pay no corporate tax but instead pass it through to shareholders to be taxed at the individual level.
REITs pay no corporate taxes if: at least 75% of total assets are classified as real estate or mortgage loans
at least 75% of revenue is derived from property rent or mortgage interest
the company owns no more than 10% of the stock of another company unless the other company is a real estate-related one
at least 90% of taxable income based on GAAP accounting (excluding capital gains) are distributed as dividends
capital gains are reinvested through a 1031 exchange or distributed as dividends – otherwise, they could be subject to taxation
the company is managed by an at least partially independent board of directors Failing to meet any of these requirements disqualifies a company from becoming a REIT.One of the most attractive features of REITs, as you can see from the bullet point list above, is the avoidance of double taxation. For most corporations, income is taxed once at the corporate tax rate and then taxed again when profits are returned to shareholders via dividends at a 15% or 20% tax rate (depending on the shareholder’s tax bracket).However, for REITs, in exchange for avoiding double taxation of the same dollar of income, dividends are taxed at each individual shareholder’s personal income tax rate, which can run as high as 37% for top marginal income. Consider, though, that for individuals making between $85,000 and $163,000 per year, the bulk of one’s income will be taxed at between 22% and 24% rates, not including the effects of any deductions like mortgage interest.Average effective tax rates, accounting for all deductions, are lower for all income quintiles than the nominal rates would suggest.In 2018, using Tax Policy Center data , we find that the average household income of the middle quintile in the US was $63,572. For the fourth quintile, the average household income was $101,570, and for the top […]