REITs 101

What is a REIT?

A REIT is a real estate investment trust which is a special tax designation for companies that derive a majority of their revenue from real estate.  Specifically, a REIT must have at least 75% of its assets in real estate or cash and derive at least 75% of its revenues from real estate.  Then, to maintain REIT status, a company must pay out at least 90% of its taxable income as dividends to shareholders.

There is a clear and big advantage to jumping through these hoops: No corporate tax.

Tax advantages of a REIT

REITs do not pay corporate tax.  Instead, REITs are treated as a pass-through entity in which they pass their taxable earnings to shareholders in the form of dividends and then the shareholders are taxed on their dividends/capital gains.

This avoids the double taxation that most companies suffer from in which the company is taxed on its earnings and then the shareholder is taxed on their dividends and/or capital gains.

It is quite clearly an advantage with the main downside being that the company has to comply with REIT rules.  For a company like Microsoft, complying with the REIT rules is virtually impossible, but for a company that primary earns its revenues from real estate it is quite straight forward.

One can also get additional tax advantage through investing in a REIT based on how their distributions are allocated for tax purposes.  REIT dividends can be taxed at different rates and each REIT varies significantly in the types of dividends they pay.  Each of these has different implications for an investor’s net after tax realization.

REITs primarily pay dividends of 3 different types:

• Ordinary income – Section 199A dividends that come with a 20% deduction through the end of 2025 (the highest effective tax rate on Qualified REIT dividends is typically 29.6%)
• Capital gains– taxed at the lower capital gains rate (20% maximum tax rate)
• Return of capital – Return of capital distributions are not taxed when received, but instead reduce an investor’s tax basis, deferring taxes until the sale of the stock.

What counts as real estate in the eyes of the IRS?

There are obvious things like houses and commercial real estate like shopping centers and apartments, but quite a few other things also count.

To count as real estate, a property has to be stationary and passive in its function.  Thus, anything from land to communication towers is considered real estate.  The passivity of function is a key distinction though as the cell towers themselves are real estate, but the equipment attached to them is not REITable.  Similarly, the land or rooftops underneath solar panels and even the brackets and hardware to which the panels are affixed counts as REIT-valid real estate, but the panels themselves serve an active function (energy production) and are not REIT qualifying.

This is why many REITs function as an entity that owns the hard real estate and leases it out to an operator who performs the active functions.  It maximizes the tax efficiency of the supply chain.

While hundreds of different property types qualify for REIT status, REITs are primarily in 20 distinctly different economic sectors.

3 main types of REITs

• Equity REITs – those which directly own income-producing real estate
• Mortgage REITs – those which collect interest income by financing real estate
• Non-traded REITs – Can be either equity or mortgage in style but are not listed on a public stock exchange

Publicly traded equity REITs tend to be the better area as mortgage REITs struggle in certain interest rate environments and non-traded REITs often have high fees.

Reasons to invest in REITs

There are 3 primary advantages to investing in REITs as part of or a staple in one’s portfolio.

1. Higher returns: Equity REITs have materially outperformed the S&P over long time periods.

The reason for the outperformance is that their tax savings result in more of their earnings going to shareholders.  Instead of paying corporate tax to the government, REITs reinvest some of their cashflows in growth and pay out the rest to shareholders as dividends.

2. Diversification:  REITs have historically had a low correlation with other asset classes making the inclusion of REITs in a portfolio volatility-reducing.
3. Transparency: Most REIT revenues come in the form of contractual income from tenants.  This provides greater visibility into future earnings than most other investment sectors.
4. Reliable income: REITs have higher dividend yields on average than the broader market.

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