Tax Strategy for the Week (June 28th, 2013)

Real Estate Investment Trusts

Tax Issue

Investors often seek to diversify the assets they hold by investing in the real estate market. A direct investment in real estate, however, requires the investor to be quite savvy in how he or she conducts the day-to-day management of the property. Often, an investor may have limited cash or poor credit and cannot invest in such property.

Applicable Tax Law

  • A real estate investment trust (REIT) collects investment money from several investors and uses this to purchase commerical real estate. The rental income is passed on to the investors.
  • An equity REIT ownes and operates income-earning real estate.
  • Mortgage REITs offer real estate financing rather than ownership and operation of the properties.
  • REITs are required to pass at least 90% of gross income on to investors annually.
  • REITs do not pay tax at the trust level, unlike a corporation which pays tax on profits before distributing to shareholders.
  • Dividends from non-traded REITs are taxed as ordinary income to the shareholder.
  • REITs will often pass through depreciation to the shareholder in the form of return of capital. This reduces the basis for the investor.

Tax Planning Strategies

Taxpayers seeking to diversify investment holdings by investing in real estate should consider an investment in a REIT. A REIT can offer an investor the ability to invest in a diversified portfolio of income-producing real estate without the hassles of investing directly into one or two properties. Because of the return of capital feature, a REIT will pass through tax-favored income to the investor.

Small Investment. Investment minimums can be as low as $1,000 for non-traded REITs. When compared to an investment in single property, such as residential real estate, it is easy to see how an investor can diversify into real estate without the burdens of investing a lot of cash or taking on a mortgage.

Types of REITs. Equity REITs will take ownership of property and lease the properties to various entities. An equity REIT may invest in one type of property or may diversify into many different types of property.

·         Retail properties

A mortgage REIT will loan investors’ money to companies seeking to purchase real estate. The REIT will collect the interest paid on the mortgages and pass the income on to investors. Generally, the REIT will have a senior security interest in the property to protect against default.

Publicly-traded REITs. Publicly-traded REITs are investments that are purchased on the market. The REITs trade like stocks and the price fluctuates with each purchase or sale of the security. Because of this, investors can buy and sell shares of publicly-traded REITs anytime Shareholders receive distrubutions from the REITs in the form of dividends.

Non-traded REITs. Non-traded REITs are offerings made by prospectus. An investor buys shares, or units through the offering and receives distrubutions from the REIT in the form of dividends. There is no open market to trade the REIT on, so an investor generally must hold the REIT until a liquidating event occurs. Liquidation events include:

·         Conversion to a publicly-traded REIT by listing on a public exchange.

·         Liquidation of individual properties.

·         Selling all assets to a third party.

Although not liquid, some non-traded REITs offer a repurchase plan. Restrictions ally and the REIT may revoke the repurchase plan based on economic conditions.

Capital Gains. One of the major benefits of owning REIT is the potential for future long-term capital gains. While waiting for the REIT appreciate in value, investors earn a consisten income stream. Capital gains are reflected in an increase, if any, in the share price for publicly-traded REITs. For non-traded REITs, the capital gain is realized at the time of liquidation.

Possible Risks

·         Non-traded REITs do not have a market within which to sell existing shares. These REITs can sometimes offer to repurchase shares from ain investor at a reduced price. Also, third party investors may offer to buy the shares at a deeply discounted price.

·         Publicly-traded REITs can experience fluctuation in share value, very much like a mutual fund or stock.

·         Because they are generally illiquid, non-traded REITs generally have investor suitability requirements. This means that investors ned to have a high net work and / or high income in order to qualiify for the investment.

·         Dividends from non-traded REITs are taxed as ordinary income to the shareholder than than quanified dividends.

·         Non-traded REITs can be very expensive. Typically, 10% of the amount invested is allocated to sales and administrative costs.

·         Management changes within a REIT can greatly affect the performance of the REIT.

·         A mortgage REIT could experience a default on a mortgage.

·         Although leases on properties held by a REIT are generally secure and long-term, default on the lease can create havoc for the REIT. The property would need to be re-leased and finding a suitable tenant might prove challenging.

·         A conflict of interest can exist within the REIT. Individuals within the management of the REIT may also benefit by being property managers of the assets purchases by the REIT. The REIT will pay ongoing managementfees to the property manager.

·         An equity REIT may also have the ability to borrow to purchase more property. This leverage will cause the REIT to be less profitable in times when the economy is not strong.