What’s the deal with Real Estate Investment Trusts?
The Beginning
As an example of how the federal tax system gets modified, a bill to extend the excise tax on cigars (called, to no one’s surprise “Cigar Excise Tax Extension”) got amended and when passed, allowed creation of real estate investment trusts. That was in 1960.
It allows incorporation of companies in real estate to sell shares.
Owning REITs does add diversification to one’s portfolio.
There are various rules that companies must adhere to to qualify as REITs. The most notable of these is that REITs must distribute 90% of their taxable income to shareholders as dividends.
Dividends
Since 90% is a big number, dividends from REITs are generally higher than for other kinds of companies. Sounds good, yes?
Yes and No
Dividends are good, so what’s not to like? Well the devil is in the details as is said. REIT dividends are generally not “qualified”. This means that REIT dividends are taxed as ordinary income. By contrast, regular qualified dividends from non-REIT companies are taxed at a lower rate.
Interest Rate Sensitivity
All companies that borrow are sensitive to interest rates. REITs are no exception, although they are very sensitive compared to average companies. Therefore, when interest rates change, REITs are strongly affected.
And Of Course
Needless to day, REITs are most sensitive to the general economy, and especially the real estate market. Most REITs specialize on one aspect of real estate. For REITs that specializes in malls, the state of mall attendance and retail companies in general has an outsized effect on their fortunes. The same applies to REITs that specialize in other areas of the economy.
These sensitivities all translate to volatility.
Other Sides
Firstly, the tax situation as mentioned above adds complexity. Secondly, sometimes distributions from REITs are determined to be “return of capital”. ROC is not taxed as dividends. Which sounds great. However, ROC lowers one’s purchase tax basis. This could mean a larger capital gains tax than expected when you eventually sell. This certainly can complicate things such as understanding one’s tax liability, and record keeping,
As a result, while I own some REITs, I have decided not to increase my positions in REITs.
Yourself? How do you handle REITs? Let me know here.
The illustration of Lake Patenggang, Java is from the 1854 book Java-Album by Franz Wilhelm Junghuhn. Courtesy Rijksmuseum, Amsterdam, Netherlands.
The post REITs appeared first in Smile If You Dare.