An increasing number of yield-starved investors are finding refuge in one of the last bastions of high-yield and relatively safe investments – real estate investment trusts (REITs). With dividend yields averaging twice those found in common stocks, some as high as 10% or more, you might question the safety and reliability of REITs, especially for conservative income-seeking investors. REITs should play a role in any diversified growth and income-oriented portfolio. REITs are really all about the high dividends, and they can offer some capital appreciation potential.
How Do REITs Work?
A REIT is a security, similar to a mutual fund, that makes direct investments in real estate and/or mortgages. Equity REITs invest primarily in commercial properties, such as shopping malls, hotel properties and office buildings, while mortgage REITS invest in portfolios of mortgages or mortgage-backed securities (MBSs). A hybrid REIT invests in both. REIT shares trade on the open market, so they are easy to buy and sell. The common denominator among all REITs is that they pay dividends consisting of rental income and capital gains. To qualify as securities, REITs must pay out at least 90% of their net earnings to shareholders as dividends. For that, REITs receive special tax treatment; unlike a typical corporation, they pay no corporate taxes on the earnings they pay out. REITs must continue the 90% payout regardless of whether the share price goes up or down.
REIT Dividends and Taxes
The tax treatment of REIT dividends is what differentiates them from regular corporations, which must pay corporate income taxes on their earnings. Because of that, dividends paid by regular corporations qualify are taxed at the more favorable dividend tax rate, while dividends paid out by REITs do not qualify for favorable tax treatment and are taxed at ordinary income tax rates up to the maximum rate of 39.6% plus the separate surcharge on investment income of 3.8%. A portion of a REIT dividend payment may be a capital gains distribution which is taxed at the capital gains tax rate. Investors receive reports that break down the income and capital gain portions. Investors should only hold REITs in their qualified retirement accounts to avoid higher taxation.
The Power of Dividend Reinvestment
Generally, when dividends are paid out, investors receive them as checks or direct deposits that accumulate in investors' cash accounts. When that occurs, investors must decide what to do with the cash as they receive it. Many companies and an increasing number of REITs now offer dividend reinvestment plans (DRIPs), which, if selected, will automatically reinvest dividends in additional shares of the company. Reinvesting dividends does not free investors from tax obligations.