- In a REIT, investors pool their financial resources into a fund, which in turn is invested in a variety of real estate projects. These projects are in the form of investment properties, and hence the income derived from REITs is mostly in the form of rental receipts. Furthermore, the investment properties are commercial in nature, and thus represent offices, retail stores, hotels, large apartment buildings and industrial complexes.
- The United States Securities and Exchange commission outlines strict rules regarding the structure of REITs. A REIT must have at least two thirds of its real estate portfolio comprised of a major property type, such as offices and shopping malls. The remainder of the REIT may be invested in less common real estate assets, such as parking lots, storage facilities, golf courses or even prisons. Many REITs diversify away from the main types of real estate in order to minimize the REIT's risk. Furthermore, at least 75 percent of assets must either be in real estate, cash or bonds. As for its income, 75 percent must come from the REIT's real estate holdings. Also, there must be at least 100 shareholders of any given REIT.
- Importantly, at least 90 percent of the taxable income derived from REITs is distributed to the REITs shareholders. This has important tax implications. Firstly, REITs are not taxed at the corporate level. Instead, tax is taken out of the income of each individual shareholder. This tax is treated as ordinary income, and is, thus, taxed at a federal and state rate appropriate to its level. When a REIT sells off a portion of its portfolio, the excess of earnings are taxed as capital gains, not as income. Because REITs are not taxed at the corporate level, REIT managers are free to buy and sell real estate investments without worrying about income tax costs and constraints. This theoretically creates a more profitable portfolio.
- Because REITs invest in real estate, they are still bound by the relevant real estate tax rates. Such tax is separate from income or capital gains tax, and is administered at the corporate, rather than shareholder level. As a result, the income shareholders derive from REITs may fall. Another tax disadvantage lies with high-yield REITs. Most state income tax rates operate on a progressive system, where higher income levels entail higher rates. Because a shareholder cannot control the amount of dividend he is to receive each quarter, he may find himself in a higher income bracket. Those who were previously on the border of an income tax bracket may find themselves paying a considerably higher amount of tax than before.
previous post