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.
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