Real estate investment trusts, or REITs, are an excellent way for investors to earn consistent income on their investments.
The history of REITs in the United States goes back to 1960, when Congress passed a law making it easier for everyday investors to gain access to the real estate market.
With hundreds of REITs now available through any online brokerage, you can add real estate investments to your portfolio with the click of a button.
Better yet, REITs allow you to avoid many of the headaches of owning real estate directly. A REIT comes with a management team that handles the details of real estate property ownership so you don't have to.
But another one of the benefits of REITS is their unique tax advantages.
REITs may be available on everyday stock exchanges, but they are structured differently than typical stocks. That's to your advantage because the resulting tax benefits of REITS give you the opportunity to maximize your gains over time.
Here are three big tax benefits you get when you invest in REITs...
When a typical corporation makes money, it has to pay taxes on its profits.
If it pays a dividend to shareholders, that's after-tax money that goes into your pocket.
And then you have to pay taxes on those dividends.
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So you're paying taxes on money that was already taxed when the company booked its profits.
That's not the case with REITs, though. Thanks to their special classification, REITs can skip the first round of taxation on their earnings. That money is only taxed after it's in your pocket, not before.
The catch is that the REIT has to follow the 90% rule. That means the company has to pay out at least 90% of its taxable earnings as dividends to shareholders.
As long as they do that, REITs function as "pass-through" entities. Their ordinary operating profits go directly to you, the shareholder. Therefore, those profits don't need to be taxed until after you collect them. And they will be taxed at your personal tax rate, as if the pass-through company never touched it.
The 90% rule allows regular investors to enjoy passive income from real estate investments even with a relatively small amount of capital.
Usually, dividends are taxed at your ordinary income tax rate. But thanks to the next two tax benefits, that's not always the case with REITs...
Real estate trusts are a different animal from typical corporations. So it makes sense that their accounting practices are different.
In particular, a REIT takes depreciation of assets into account, by recording it as an expense.
You still might get the same dollar amount in dividend payments. But when depreciation is considered, a portion of that dividend may be considered "return of capital" rather than ordinary income.
And for most investors, the tax rate on return of capital is lower than it is for ordinary income. So you'll pay a lower rate on that portion of your REIT income.
Best of all, for some of that income, you may not have to pay taxes at all.
That brings us to our final tax benefit to investing in REITS...
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Since 2017, there's been another huge incentive to invest in REITs.
The tax bill that was signed into law that year allowed a 20% tax deduction on pass-through income.
Remember that as long as a REIT follows the 90% rule, the income you receive qualifies as pass-through income. So in most cases, you can get one-fifth of your REIT dividends tax-free.
For those in the top income tax bracket, that effectively knocks your tax rate on all your REIT income down from 37% to just under 30%.
There is a caveat here. The full deduction applies either to households with a joint taxable income lower than $315,000 or to individuals with a taxable income lower than $157,000.
A reduced tax deduction still applies to households with a joint income up to $415,000 or individuals with income up to $207,000.
Check with a tax professional to be sure about the tax implications of your REIT ownership. But for many investors, the tax deduction of up to 20% could mean a substantial increase in income and a powerful motivation to make REITs a significant portion of their portfolios.
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