Real estate investment trusts (REITs) are a popular investment vehicle for those interested in the real estate market without the direct ownership of property. However, understanding the complex tax structure is crucial for investors to make money with REITs. A financial advisor can help you figure out how this investment could fit into your portfolio. Here’s a general breakdown of the tax advantages and risks.
How REITs Work
Real estate investment trusts (REITs) are unique entities that own or finance income-producing real estate across various property sectors.
REITs are designed so that a variety of investors can fund these real estate purchases without having to put in the work of finding properties or managing them. The management team will take care of all the work in that regard while the investor just enjoys the benefits of successful investments.
When it comes to taxation, the tax burden frequently falls on the investors, who pay income tax on the dividends they receive. The tax implications of investing in REITs can vary given the type of REIT and the investor’s individual tax situation (we will explain taxes in a section below).
Understanding the Mechanics of REITs
REITs are corporations, trusts or associations that own and manage a real estate portfolio. As such, they provide avenues for individual investors to earn a share of the income produced through commercial real estate ownership or financing.
This investment essentially bridges the gap between real estate and equity investments. It allows investors to buy shares in real estate ventures like if they were buying ETFs. In this comparison, both financial investments:
- Can provide diversified exposure to a specific asset class
- Are typically traded on stock exchanges
- Can offer dividend income
Take note: While REITs can add diversity to your investment portfolio by spreading your risk across different asset classes, they can also be aggressive investments with his risk, comparable with stocks or cryptocurrency.
The Different Types of REITs
There are different types of REITs that you might be interested in investing in, depending on what you’re trying to achieve. Three common types include:
- Equity REITs own and manage real estate properties and collect rent
- Mortgage REITs lend money to real estate owners and operators either directly through mortgages/loans or indirectly through acquiring mortgage-backed securities.
- Hybrid REITs are a combination of equity and mortgage REITs.
All three types of REITs have different risk and return profiles. Therefore, you should consider your personal financial goals and risk tolerance before investing.
Understanding the Taxation of REITs
The taxation of REITs follows specific rules. Most notably, as long as a REIT distributes at least 90% of its taxable income as dividends to its shareholders, it is not required to pay any corporate income tax.
Additionally, investors might receive taxable dividends or other payouts when they cash in their ownership of the REIT, similar to how you would sell a stock.
The increase of your investment in a REIT is going to be treated pretty similarly to how an increase from a stock increase would be. This means that you’ll be paying capital gains tax on that increase and the amount you’ll pay depends on your other finances.
Take Advantage of This Tax Benefit Before It Expires
There is a current tax benefit for investing in REITs that is set to expire, at the end of the 2025 tax year. Individuals can currently deduct 20% of the pass-through income coming from REIT investments.
This can incentivize you to invest in a REIT right now as you may pay significantly less in taxes than you would have before this benefit was provided.
There is no guarantee that this tax benefit will be extended beyond 2025.
Bottom Line
REITs can provide a way for investors to participate in the real estate market and offer unique tax benefits. However, you should understand the tax implications and risks before investing to take full advantage for your portfolio.
Tips for Investing in Real Estate
- There are numerous ways to invest in real estate, including REITs. An experienced financial advisor can help you navigate the world of real estate investing and help you determine which, if any, are the best choices to help you reach your financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before investing in a REIT, make sure you have the right amount of money so that your investment becomes worthwhile.
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