This is part III of the series, Unconventional Income From Uncommon Stocks. The series is meant to be an absolute beginner’s introduction to uncommon stocks. The focus of this post is on REITs.
Imagine owning and renting out property without the hassles of maintaining it! You don’t have to worry about finding renters, collecting rent, paying taxes or even maintaining the property. And best of all, you can sell anytime, making such investments even better than owning physical real estate.
To understand REITs, imagine a group of people pooling their money to buy some property and then renting it out. The rent collected is shared among the group proportional to the money they contributed to the pool. Come tax time, each individual in the group pays taxes proportional to his share of the property.
What I just explained is what’s called an Equity REIT. Equity REITs invests in Real Estate properties and generates cash flow from the rents collected. There is one more kind of REIT called a Mortgage REIT. Mortgage REITs lends to borrowers and generates income from the mortgage interest it collects.
To avoid taxation at the trust level, REITs must distribute 90% of their income to its unitholders. Which means, the yields from REITs are usually pretty high and avoids double taxation of dividends. Another advantage of REITs is that not all of the dividend received is taxable. Some of it is considered return of capital due to depreciation and other expenses and are not taxable! Return of capital also reduces your cost basis, which means the longer you hold on to the REIT, the lower your cost basis gets and you pay taxes on the capital only when you sell your share (tax deferred). You will however pay taxes on the portion of dividends that comes from actual earnings.
When it comes to picking a type of REIT, there are lots of choices. There are REITs specializing in Malls, Apartments, Healthcare, Self-Storage, Industrial, Offices, Mortgages etc. Or you can get a bit of everything by choosing a REIT index fund!
Here’s a comparison of a REIT that I like and own, with the S&P 500 for the past 10 years.
That’s without taking into account the dividends! The current yield on this REIT is over 5%!
Realty Income, the REIT used above is a free standing REIT that leases properties to commercial enterprises. It has properties in over 49 states with over 37.6 million square feet of leasable space! It also pays monthly dividends to boot!
REITs complement a balanced portfolio and its income generating potential makes it ideal for investors seeking regular income.
Sounds too good to be true, what’s the downside of owning a REIT?
First, your dividends are taxed as ordinary income which is normally higher than dividend tax rates. So yes, you’ll pay more for the dividends.
Second, you have to do your bit to calculate depreciation and expenses to reduce cost-basis. All this makes tax time much more involved that owning a dividend paying stock.
What about Mortgage REITs?
Their business model is very simple, but do remember, they are highly sensitive to rate increases. Don’t let their high dividends fog your judgement!
Should REITs be held in a retirement account or a regular account?
Since income from REITs are taxed at individual income tax rates, it makes sense to hold them in a retirement account. This also means no hassles, come tax time!
What are your thoughts on having REITs in a portfolio? Do you own any REIT stocks? Are you planning on increasing your allocation?