Why REITs (Real Estate Investment Trusts) are an Awesome Way to Quickly Invest in Real Estate

Hello everybody, welcome back. Stephen Morris here with AdviseRE. And today we will be talking about REITs, or Real Estate Investment Trusts. Very exciting form of real estate ownership. And it is actually one of the easiest ways that you can get into real estate investment.(…) So what are REITs? Well, REITs are a relatively new area of the tax code passed in the 1960s by Congress. And it was to provide a vehicle that would effectively have one level of taxation for real estate investment companies.

(…)

The purpose of the REIT is to provide a vehicle for investors to make a investment into real estate without having to deal with all the management issues and all the direct ownership and property issues. And also just be able to transact and be able to trade in and out of properties in a much easier capacity than having to actually go out and list your property out on the market and then go out and find a buyer and open escrow and all that sort of stuff. A lot of REITs fall into several categories. There are some that are publicly traded. There are some that are private. And then there’s even ones that hold only one asset. Those are called baby REITs, colloquially here in the tax world. They’re single asset REITs. So the question is, can you go out and open a REIT tomorrow?

(…)

It’s a little more complicated than that. So there are quite a few rules around opening REITs and the rules and regulations around them are quite stringent. And if you fail any of them, then you’re no longer gonna be a REIT. You’ll be a corporation tax under corporate tax rules and you won’t get the tax benefits that a REIT affords to its investors. So what are those rules? There’s quite a numerous amount of them. But the first one is you’re gonna have to have at least 100 shareholders. And so that requirement is waived for the first year as you continue to raise capital. But by year two, you’re gonna have to have a hundred shareholders in the business. And one way to get a hundred shareholders is usually you’ll pay for a service, they’re out there, and they’ll give you the additional shareholders that you need, maybe they own 0.01% of your company, and they’ll provide the amount of shareholders required to meet the law. That’s generally not too difficult. But the other major one is that no shareholder can own more than 10% of the REIT. So you can have a minimum of 11 shareholders at 9.9%.(…) But if someone were to own 10%, that would be problematic and you’d immediately have to dilute their interest out or they’d have to sell. Otherwise, you could jeopardize the REIT status and potentially get back to the C-Corp world, which is what we’re trying to avoid. The major feature of a REIT is that they have to distribute 95% of the earnings that they earn from their properties to their shareholders. So generally speaking, unless the REITs in financial dire straits, then almost every REIT’s gonna kick off dividends to its shareholders, and they do so through the form 1099. And those dividends are not taxed at the preferential rate of 20%, like a qualified dividend would be the reason being that they aren’t taxed at the corporate level. And so they’re not gonna get that special tax benefit(…) passed down to the shareholders.(…) Generally speaking, REITs pass down 100% of their earnings to their shareholders and they receive a dividends paid deduction for making those dividend payments to their shareholders. Under normal corporate tax law, dividends are not considered to be deductions for tax purposes, rather they are a reduction of equity and the dividends received by the shareholders are taxed again at a 20% preferential rate should they be qualified. So what are some types of investments that REITs make? Well, they run the gamut of all types of real estate classes. Now there are many REITs that do the traditional type of real estate. There are multifamily REITs, they only specialize in apartments. There are retail REITs that only do shopping centers, office REITs, there’s industrial REITs as well. And there’s even other REITs that do certain other areas. For example, timber,(…) it’s land.

(…)

They also have telecom or data center REITs, right? Those are great. Sell towers and even prison REITs. Believe it or not, prisons are considered to be a form of real estate and they do have long-term leases with their tenants, whether they like it or not. And there are actually publicly traded REITs out there that do sell their shares if you’d like to own a piece of a prison. Kind of an interesting investment topic, but generally a fairly safe investment opportunity. REITs typically gain their capital from investors directly in the form of equity. And of course they’re gonna use debt financing like the vast majority of real estate investors would use. The REITs can also pass down or do 1031 exchanges to avoid taxable income. And on top of that, they can also take depreciation deductions just like any other real estate investor. One major advantage of REITs is, although they’re not truly a pass-through entity, like a partnership or an S-Corp would be, REITs effectively are not taxed because of their dividends paid deduction that they receive. Now, one of the major advantages to that is that if you are say, for example, an investor in a REIT that owns properties in California, Kentucky, and New York,(…) under a normal partnership that would own these properties, the owner or the partner in that company who owns a piece of those assets would have to file a state tax return in California, Kentucky, and New York. But under REITs, REITs just file a 1099. You’ll pay taxes based on whatever state taxes that you have, and of course federal income tax. And you’re done. So it minimizes the amount of tax filings that you have to do as it relates to the state level. One other requirement to consider for REITs, if you decide to open up one, is that more than 75% of your assets has to be in real estate. If you drop below that number, again, you’re gonna potentially lose your REIT status, and as a result, come fall back under the corporate income tax rules or the two levels of taxation that we commonly refer to. So what are some disadvantages to owning REITs? Well, number one is you have to own less than 10%. So by default, you can never control a REIT fully because of the limitations on ownership. Number two is market volatility. So with normal real estate holdings, generally speaking, if you just own the asset directly, you’re not gonna see the valuations move up and down that much. REITs function a little bit differently, especially the publicly traded ones. You might see the stock rise and fall throughout the year, and this could dramatically impact valuations and could potentially impact yield. If you buy it too high of a price, the dividends received on that particular investment might have such a low yield that you kind of jumped in at the wrong time. That would be unfortunate,(…) and that’s kind of one of the other disadvantages.(…) And lastly, as I mentioned, REIT ownership does not have the benefits of the lower favorable qualified dividend tax rate that I mentioned. In other words, the dividends that you receive from the REITs could be taxed as high as 37%

(…)

versus 20% for a qualified dividend. Had you gone out and invested in a corporation, that’s not a REIT that normally would pay off dividends. What are some advantages, however? So as I mentioned, number one is ease of tax return compliance. You don’t need to file multiple state returns regardless of how many assets the REIT owns all over the country because you’re only gonna receive $110.99 for your REIT ownership. Number two, it’s great for foreigners. So if you’re a foreigner and you’d like to invest in United States real estate, directly doing so can actually trigger quite a few foreign tax laws. Number one being the FERPDA rules, which is the Foreign Investment and Real Property Tax Act. And if you were to invest directly as a foreigner and ultimately sell the property,(…) then all that income would be considered to be ECI and would be subject to a special 10% withholding weight on the gross sales price, which would then force you to come in and file a tax return to calculate your gain. And ultimately, you’ll probably get a tax return for the gain that you have on your property. This is quite a large compliance effort. There’s a lot of disclosures you gotta do, especially during escrow, that you’re a foreign investor. And so it’s one of the things that might deter a foreign investor from directly owning real estate in the United States. However, owning REIT shares is not considered to be a real estate investment. It’s considered just be plain old ownership in a corporation. And when ultimately you decide to sell, then those gains would not consider to be ECI. They would be exempt from US income tax. And it would only be subject to taxes or in your particular country, whatever that might be. Lastly, the other advantages, it’s very easy to own one. You can go onto your E-Trade or Schwab account to pick up some REIT shares just by clicking a few buttons. And just like that, you’re a real estate investor just like anybody else. That’s an awesome advantage. It might get you into particular areas that you just don’t have access to. For example, if you wanna own a piece of a $300 million office building, you might not have the capital to do that, but you can certainly buy into a REIT that owns the $300 million office building and be invested alongside with them, which is fantastic if you believe that that’s the type of investment that you believe will yield the best results for you. So I hope this primer helps you understand a little bit about how REITs work and their advantages and disadvantages in doing so. I am a strong proponent of REITs, especially as it relates to investing in asset classes that are not easily accessible for smaller investors who have less net worth and less ability to go out and buy these assets directly. And so strongly recommend taking a look at them to add to your real estate portfolio. If this is of interest to you or you’d like to learn a little bit more about REIT strategies, then feel free to contact us here and we’d be more than happy to discuss this. Thanks so much for watching and look forward to seeing you soon.