If you were to ask most people about what they think is the best way to invest in real estate, you would get a variety of answers. Some might tell you to buy foreclosures and flip them. Others might suggest that you should buy apartment buildings and manage them as income property. While both answers are correct, they are just two of many options for building wealth through real estate. What most people don’t realize is that it’s possible to invest in real estate without ever actually buying property. They can do this by investing in a real estate investment trust or REIT.
What is a REIT
A REIT is a managed fund that invests in real estate or something related to real estate. The goal of every REIT is to maximize profit and minimize risk for investors by building a large portfolio across a wide geographic area. Buying into REITs allows investors to get a slice of a diversified real estate pie without having to buy property outright.
The investments offered by REITs are carefully chosen, with the aim of offering investors safe, steady returns. This doesn't mean there is no risk of loss with REITS, however, well-managed REITs consistently meet the goals laid out in their investment prospectus.
Three Types of REITs
Although there are many different types of REITs, the most common type is known as an Equity REIT. Equity REITs own and operate large portfolios of commercial real estate, sometimes across several states (or even the entire country). The properties in equity REITs are chosen by the fund manager, who is usually a seasoned real estate professional.
REITs make money by taking a percentage of all building-related revenue (e.g., rent, late fees, parking charges) or selling properties in the portfolio at a profit. This happens when market conditions dictate (e.g., the fund manager believes the building has reached its peak market value) or the REIT wants to raise funds to purchase new properties. In either case, equity REITs pool existing funds with contributions from new investors to grow the portfolio and maximize annual returns.
The second type of REIT is known as a mortgage REIT, which operates differently from equity REITs in several respects. Instead of buying and selling property, mortgage REITs combine investor contributions with money borrowed at low-interest rates to buy mortgages, mortgage-backed securities and other debt-related financial products. Mortgage REITs turn a profit when the interest rates on the loans they purchased exceeds the interest rate on the money the REIT originally borrowed.
Mortgage REITs have several potential benefits for investors. The first one is that the loans mortgage REITs buy are secured by the properties being financed. It’s also probably easier for mortgage REITs to sell off a bundle of mortgages than it is for equity REITs to sell buildings when the market goes south. That’s because mortgages offer fixed returns for fixed periods of time and buildings do not. With that said, mortgage REITs are very sensitive to fluctuations in interest rates.
The third type of REIT is known as a hybrid REIT. Hybrid REITs invest in both equity (buildings) and mortgages. The idea behind a hybrid REIT is pretty simple; it offers investors the best of all worlds. By investing in both equity and mortgages, hybrid REITS make themselves a “one-stop shop” for real estate investing. Investors can choose among a number of different offerings and diversify their real estate holdings, while still having all of their money managed by the same outfit.
How are REIT Dividends Taxed?
REITs can generate many different types of income, even for the same investor. The distinction between the income types is important because the type of income generated determines the tax rate the investor pays on the income. Every investor who holds a stake in a REIT receives a form known as a 1099-DIV tax form, which breaks down the profits or losses from their investment. This form is distributed once per year, just like the W-4 or 1099 from your job.
Under most circumstances, the income generated by equity REITs is treated like miscellaneous income and taxed at the marginal tax rate. This means that most equity REIT income is taxed according to whatever tax bracket those earnings place the investor in. So, for example, a $1,000,000 return on an equity REIT would be taxed at the highest marginal tax rate of 37%.
A notable exception to this is capital gains. If part of the dividends paid to an investor were earned through a profit made by the REIT on the sale of a building, the investor dividend will be taxed at the standard capital gains rate of 0% (for a loss or a 1031 exchange), 15% or 20%. The determining factor in the individual investor’s tax rate is their income level. Investors in the top income brackets are taxed at the maximum capital gains rate of 20% while investors in lower income brackets are taxed at 15%.
There is also something known as nontaxable income. Investors can earn nontaxable income when the REIT’s dividends and expenses total more money than the REIT earns in a given year. The most common cause for this is the REIT taking writing off large losses to depreciation on one, or several of its holdings in the same calendar year. In cases where this happens, the dividends paid out to investors will be classified as nontaxable income on their 1099-DIV form.
The Tax Cuts and JOBS Act
The Tax Cuts and Jobs Act of 2017 also had an impact on REIT taxation. Specifically, the act contained a provision that created a 20% tax break for qualifying “pass-through income.” Certain REIT dividends are covered under this provision. However, that tax relief may not be permanent because the provision allowing this particular tax break expires in 2025.
Are REITs a Safe Investment?
This is a trick question because all investments carry risk and there is no such thing as a “safe” investment. In spite of having the best fund managers armed with the best information, some REITs will lose money for their investors. With that said, most REITs are run by very seasoned professionals with highly successful track records of earning money for their investors. That’s why putting your money into REITs is probably a better, more reliable wealth-building option than buying properties to flip or manage yourself as a landlord.
If you’re worried about tax exposure, there are other investment options, such as bonds, exchange-traded funds (ETFs) and IRAs, all of which will offer you better tax advantages than many REITs. But which type of investment is right for you depends on what you’re more concerned with — tax exposure or profit potential.
Your individual risk tolerance is also an issue here. It’s unlikely that a REIT’s value will explode several hundred percent in one day the way you might see with a hot stock. It’s also equally unlikely that a REIT will lose most (or all) of its value in one day’s trading.
Benzinga’s Best REITs
If you’re interested in REITs, you’ve come to the right place. Benzinga loves providing resources for investors and it offers a lot of great information on all things REIT-related. In fact, Benzinga has created a list of its favorite private REITs below. You can also view our list of best publicly-traded REITs.
REITs, Taxes and What it Means for You
REITs can be wonderful tools for wealth building. Equity REITs allow you to reap the benefits of property ownership without going through the trouble of financing and managing your own property. Mortgage REITs let you buy into mortgage backed securities and leveraged debt in a way that would be impossible unless you had millions of dollars in cash to lend. Hybrid REITs bring you the best of both worlds.
Regardless of what type of REIT you choose to invest in, if it pays a dividend, you’re going to have tax exposure. While Benzinga can lay out the broad strokes of this exposure for you, it’s always best to seek the advice of a tax professional if you have questions about how to handle investment income.
How is a REIT taxed?
The taxation on dividends paid by REITs is a complicated question. As a general rule, dividends are considered miscellaneous income and taxed at the marginal tax rate, which goes up progressively based on the size of the payout. However, some REITs have different taxation rates for capital gains and some REIT dividends qualify for a 20% reduction in pass-through income because of the Tax Cuts and Jobs Act of 2017.
At the end of the day, the best way to get the final word on REIT taxation is to get an investment prospectus from the REIT you’re interested in and consult with a tax professional.
How do REITs avoid taxes?
The short answer to that question is that REITs don’t avoid taxes. REITs pay corporate taxes and dividends paid by REITs are taxable just like any other investment income. While some REITs are able to defer taxation through the use of 1031 title exchanges or taking write-offs for depreciation, the deferred taxes are paid eventually.
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