When you dig into how REITs operate, they become fairly complex investments. Most of this isn’t as important for investors but is important for REIT operators. We will look at two specific restrictions or rules that REITs must follow.
REIT Operating Basic
REITs operate under certain restrictions, which afford REITs specific tax benefits. One of those restrictions is that REITs must distribute (i.e., dividends) 90% of their taxable income to investors. If there are no earnings to distribute, the distribution is considered a return of capital and not taxed. Paying 90% of income disqualifies the REIT from paying corporate taxes.
For investors, there may also be tax advantages from REIT dividends. Dividends typically come in two categories — regular and qualified dividends. Regular dividends are taxed at the investor’s ordinary income tax rate. Qualified dividends are generally taxed at the capital gains rate.
Return of capital might be thought of as a dividend, but as mentioned above, it is the return of principal and not taxed.
The next two sections get into the main topics of this article, which highlight two more REIT restrictions.
10% Rule
The 10% rule is related to safe harbor rules. When a REIT sells property as “inventory,” it can avoid being categorized as a prohibited transaction by meeting several requirements. One of those requirements is the 10% rule1.
This rule is based on the fair market value (FMV) of all REIT properties at the beginning of the year. At the beginning of the year, properties sold as inventory cannot exceed 10% of the FMV of the REIT’s assets.
30% Rule
This rule was introduced with the Tax Cut and Jobs Act (TCJA) and is part of Section 163(j) of the IRS Code. It states that a REIT may not deduct business interest expenses that exceed 30% of adjusted taxable income.
REITs use debt financing, where the business interest expense comes in. Under the TCJA, the business interest expense deduction is a mechanical computation.
Note that the 30% rule seems to be more dynamic than static. In 2019 and 2020, the limit was raised from 30% to 50% by the Coronavirus Aid, Relief, and Economic Security (CARES) Act. In 2021, the business interest expense calculation made the deduction more restrictive2.
The above two rules pertain mainly to REIT operators rather than investors. Investors will mostly be concerned about researching a REIT as a viable investment and the taxation of their distributions.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
