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Let’s Try a Practice Question:
Which of the following statements regarding a REIT here is accurate?
- It is an investment vehicle that passes through gains and losses to investors
- It is a type of direct participation program (DPP) that gives investors access to a broad range of real estate assets
- It is a mostly illiquid investment that passes through losses to investors.
- It may be a publicly traded investment product that passes through income but not losses to investors
The answer here is 4.
How Do REITs Qualify for Favorable Tax Treatment?
REITs are very testable on the SIE exam. Importantly, what does the REIT need, how does it qualify for favorable tax treatment? The most important thing here to remember is that REITs are publicly traded, they pass through income, but they do not pass-through losses to investors. What’s the investment that passes through both? That’s going to be a Direct Participation Program (DPP). _
A DPP is an investment company that passes through both income and losses to investors. Think hedge funds, that are generally structured as pass-through entities, passing through both income and losses. REITs only pass-through income. What are the criteria that REIT must meet in order to be able to pass through that income? We are looking for a certain percentage here; 75, 75, 90. A REIT must have 75% of its income in real estate, 75% of its assets in real estate and 90% of the income must be distributed to shareholders. If you have all three of those characteristics, you do not pay any corporate income tax passed through to the investors and they just pay their ordinary income tax. Their shareholders are taxed directly.
What Are Direct Participation Programs?
They are an alternative structured product. They are not considered investment companies. A hedge fund is a good example of a direct participation program (DPP). The way to think about it is, it’s almost like you are directly participating in the actual business itself., Whether you are a limited partner or a general partner of a hedge fund, you are exposed to that business. Your risks are limited based on whether you are a limited partner or general.
Why Would an Investor Want to Offset their Passive Gains?
For starters, what does it mean to offset a gain, and would you only want to offset a loss? The answer here would be to reduce their taxes. If you have a big gain, say you do not want to pay taxes on that, you will find a loss to help cover that. In fact, if you have brokerage accounts, or if you trade stocks, you can reduce the taxes that you will pay on profits, on the sale of any of your stocks, all by taking a few losses on other investments you have.
Written by Kris Dudchak
As a faculty member of the Knopman Marks team, Kris has found the perfect way to combine what he loves with what he knows. From the first time Kris stood in front of a classroom to teach, he was hooked on the feeling. In college, he chose to work as a TA for numerous professors. Before joining Knopman Marks in 2020, Kris was an investment banker at Citigroup working in the global healthcare group. He specialized in evaluating strategic and financial implications of business decisions for large, well-known healthcare companies.
FAQs
A Real Estate Investment Trust (REIT) is a security that trades like a stock on the major exchanges and owns—and in most cases operates—income-producing real estate or related assets.
What is the 5 50 rule for REITs? ›
General requirements
A REIT cannot be closely held. A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year, (this is commonly referred to as the 5/50 test).
What is a good amount to invest in a REIT? ›
Invest at least 75% of its assets in real estate and cash, with no more than 25% in nonqualifying securities or stock in taxable REIT subsidiaries. Derive at least 75% of its gross income from real estate, including rents and interest on mortgages.
What is the 90% rule for REITs? ›
By law, REITs must distribute at least 90% of their taxable income to shareholders. This means most dividends investors receive are taxed as ordinary income at their marginal tax rates rather than lower qualified dividend rates. Any profit is subject to capital gains tax when investors sell REIT shares.
What is a con of investing in REITs? ›
The potential downsides, or CONS, of a REIT investment include the fact that they are taxed as income, the variation in the fee structures of different managers, and market volatility due to interest rate movements or trends in the real estate market.
Are REITs still a good investment? ›
Are REITs Good Investments? Investing in REITs is a great way to diversify your portfolio outside of traditional stocks and bonds and can be attractive for their strong dividends and long-term capital appreciation.
What is the 80 20 rule for REITs? ›
80-20 Rule: At least 80% of a REIT's asset value must be in completed and income-generating real estate, with the remaining 20% able to be invested in riskier assets such as under construction buildings, equity shares, bonds, cash, or under-construction commercial property.
What is the average return on a REIT? ›
Over a 15-year period, according to Cohen & Steers, actively managed REIT investors realized an annualized 10.6% return. Of the other active strategies, opportunistic real estate funds placed second, at 9.8%. Core and value-added funds had average annualized returns of 6.5% and 5.6%, respectively, over 15 years.
What is considered bad income for a REIT? ›
If the amount the REIT receives as rent depends on the net profits of a tenant or subtenant, or if the REIT receives interest income that depends on the net profits of the borrower (in both cases, gross rents are fine), all such rent or interest, as applicable, can fail to qualify as good income for purposes of the ...
Can you live off REIT income? ›
Reinvesting REIT dividends can help retirement savers grow their portfolio's investment, and historically steady REIT dividend income can help retirees meet their living expenses.
In many cases, this can take around 10 years to occur. And with publicly traded REITs that fluctuate with the stock market, Jhangiani recommends holding onto them for at least three years.
What is the REIT 10 year rule? ›
For Group REITs, the consequences of leaving early apply when the principal company of the group gives notice for the group as a whole to leave the regime within ten years of joining or where an exiting company has been a member of the Group REIT for less than ten years.
Why is REIT risky? ›
However, REITs are not risk-free: they may have highly inconsistent, variable returns, are sensitive to interest rate changes are liable to income taxes may not be liquid, and can be dramatically affected by fees.
How does a REIT make money? ›
REITs make their money through the mortgages underlying real estate development or on rental incomes once the property is developed. REITs provide shareholders with a steady income and, if held long-term, growth that reflects the appreciation of the property it owns.
What is an example of a REIT? ›
Mortgage REITs
For example, when a family takes out a mortgage on a house, this type of REIT might buy that mortgage from the original lender and collect the monthly payments over time, generating revenue through interest income.
