Real Estate Investment Trusts, or REITs, can offer investors many of the potential benefits associated with real estate investments without the common pitfalls of direct property ownership.
REITs are either publicly traded or private, but both adhere to the same basic operational structure in order to qualify as REITs. According to the National Association of Real Estate Investment Trusts (Nareit), a Washington, D.C.-based REIT advocacy group, REITs own more than $3.5 trillion in gross assets, with more than 145 million individual investors.¹
Investors can purchase shares of REITs just like any other publicly traded stock, or they can invest in non-listed and private REITs through a broker, financial planner, or investment advisor.
Below we’ve outlined how REITs operate and how they are taxed.
What Is a REIT?
Real estate investment trusts were established in 1960 as a way to provide individual investors access to commercial real estate that typically would be well beyond the financial reach of solo and retail investors.
REITs are companies that own and operate portfolios of income-producing commercial real estate assets. They derive income from leasing space to creditworthy tenants, who typically sign long-term leases.
Some of the asset classes held within a REIT can include the following property types:
- Shopping malls
- Hotels
- Self-storage facilities
- Apartment communities
- Industrial warehouses
- Healthcare facilities
- Student housing
- Office properties
Many REITs specialize in one unique asset class, such as data centers or hospitality lodging, in an attempt to maximize management and operational expertise. REITs typically acquire and develop these types of properties as part of a well-crafted investment portfolio rather than developing or acquiring properties for sale.
Special Tax Considerations for REITs
There are a few caveats a REIT must meet in order to be viewed as such by the IRS. First, a minimum of 75 percent of assets in a REIT’s investment portfolio must be directly connected to real estate; secondly, the REIT must distribute a minimum of 90 percent of its taxable income back to shareholders as dividends.
Qualifying REITs are allowed to deduct these dividend payments from their taxable income -- that’s why many REITs attempt to pay out 100 percent of their taxable income back to shareholders as dividends so they will owe no corporate taxes, the SEC reports.²
Shareholders, meanwhile, are required to report dividend payments and capital gains on their annual tax returns. Dividend payments are treated as ordinary income, so they are taxed at the rate determined by your income and filing status.
Since investors aren’t entitled to the reduced tax rates associated with other forms of corporate dividends, they often prefer to hold shares of REITs in tax-deferred retirement accounts so tax liabilities can be delayed until they start withdrawing from their retirement accounts, the SEC reports.³
The last item of note about REITs and taxation is that they aren’t treated as pass-through entities by the IRS -- they can’t pass tax losses off onto shareholders.
Individual shareholder taxation of income derived from REITs can be complicated because REITs break out dividend payments into different classifications, such as ordinary income, long-term capital gains and return of investment capital. Consult with your tax professional if you have any lingering questions about how REITs and their shareholders are taxed.
1. About Nareit, https://www.reit.com/nareit
2. Investor Bulletin, Real Estate Investment Trusts, SEC.gov, https://www.sec.gov/files/reits.pdf
3. Investor Bulletin, Real Estate Investment Trusts, Special Tax Considerations, page 4, SEC.gov, https://www.sec.gov/files/reits.pdf
