“Real estate investment trusts (REITs) have established themselves as a means for the smaller investor to directly participate in the higher returns generated by real estate properties.”
These types of trusts were once thought of as minor offshoots of unit investment trusts, in the same category as energy or other sector-related trusts. However, when the Global Industry Classification Standard granted REITs the status of being a separate asset class, the rules changed, and their popularity increased dramatically.
Investopedia’s recent article, “The Basics of REIT Taxation,” explains how REITs work and looks at the special tax implications and savings they offer to investors.
REITs are a pool of properties and mortgages compiled and offered as a security in the form of unit investment trusts. Each unit in a REIT is a proportionate fraction of ownership in each of the underlying properties. REITs on the NYSE possessed a market cap over $1 trillion in March 2019. In 2019, 226 REITs were traded actively on the New York Stock Exchange and other markets.
REITs typically are more value-focused than growth-oriented and are primarily composed of small and mid-cap holdings. The IRS mandates that REITs pay out at least 90% of their income to unitholders. REITs provide higher yields than those usually found in the traditional fixed-income markets. They also are usually less volatile than traditional stocks because they swing with the real estate market. REITs are categorized into three types:
- Equity REITs: These own and/or rent properties and collect the rental income, dividends and capital gains from property sales, making this triple source of income type very popular.
- Mortgage REITs: These have greater risk because of their exposure to interest rates. If interest rates rise, the value of mortgage REITs can drop significantly.
- Hybrid REITs: These combine the first two categories and can be either open- or closed-ended, have a finite or indefinite life and invest in either a single group of projects or multiple groups.
REITs have to follow the same rules as other unit investment trusts. They must be taxed first at the trust level, then to beneficiaries. However, REITs must follow the same method of self-assessment as corporations. As a result, they have the same valuation and accounting rules as corporations, but instead of passing through profits, they pass cash flow directly to unitholders.
There are a few other rules for REITs, in addition to the rules for other unit investment trusts. Rental income is treated as business income to REITs, because the government considers rent to be the business of REITs. Thus, all expenses connected to rental activities can be deducted in the same way as business expenses can be written off by a corporation.
Current income distributed to unitholders isn’t taxed to the REIT. However, if the income is distributed to a non-resident beneficiary, it is subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains (unless the rate is lower by treaty).
REITs are exempt from taxation at the trust level, provided they distribute at least 90% of their income to their unitholders. However, even REITs adhering to this rule still face corporate taxation on any retained income. The dividend payments made by the REIT are taxed to the unitholder as ordinary income, unless they’re considered qualified dividends. Those are taxed as capital gains. Otherwise, the dividend will be taxed at the unitholder's top marginal tax rate.
Part of the dividends paid by REITs may constitute a non-taxable return of capital, which not only decreases the unit holder's taxable income in the year the dividend is received. In addition, it defers taxes on that part until the capital asset is sold. These payments also reduce the cost basis for the unitholder. The non-taxable portions are taxed as long- or short-term capital gains/losses.
As you can see, the unique tax advantages of REITs can mean great yields for investors seeking higher returns with relative stability.
Reference: Investopedia (May 5, 2019) “The Basics of REIT Taxation”