A REAL ESTATE INVESTMENT TRUST IS A SPECIAL TYPE OF COMPANY WITH HUGE TAX BENEFITS
A Real Estate Investment Trust (REIT, pronounced “reet”) is a special type of company. They own, operate, or finance real estate. These entities get huge tax benefits as long as they adhere to strict requirements.
REITs were created in 1960 to make it easier for investors to get real estate exposure in their portfolio. Today it’s estimated that REITs own $3 trillion in gross assets.1 REITs can invest in any kind of real estate, such as apartments, office buildings, hotels, or malls. REITs might focus on one strategy or type of real estate or may do multiple.
There are strict rules to qualify as a REIT. They are REQUIRED to pay out 90% of their taxable income back to their investors as dividends. There’s also limitations on how much of their assets and income can come from non-real estate activities and there’s requirements for a minimum number of shareholders.
So why do REITs put up with all these rules?
Because there are massive tax benefits for investors if the REIT complies with all the requirements.
Companies that qualify as a REIT don’t pay a corporate income tax. They pass their earnings on to their shareholders, who pay income tax on the earnings. This is single-taxation, compared to double taxation with stock dividends.
On top of that, because REITs are a passthrough entity, the income investors receive qualifies for the Qualified Business Income deduction. This deduction, which was new in 2018, allows REIT investors to reduce the taxable income from their investment by up to 20%.
REITs come in all sorts of shapes and sizes. They can be public, private, or public but not traded. They can invest equity, debt, or a combination. And there’s a dozen different tests they need to meet to continue to qualify as a REIT.
Here’s our overview of the different types of REITs, the tax benefits they enjoy, and the regulations they need to abide by to qualify.
Types of REITs
Public REITs trade on the stock market where anybody with a trading account can freely buy and sell shares. While most publicly traded companies make their money selling products and services, REITs make generate income and profits renting or financing properties.
Public REITs register with the Securities and Exchange Commission (SEC), publish their financial information, and trade on stock exchanges. Like stocks, the minimum investment is really low.
Anyone can buy shares of a public REITs. Shares are traded every day on the stock exchange. The share price goes up and down just like any stock. Public REITs are very liquid, because you can quickly sell your investment whenever you want.
There’s a price to pay for this liquidity. Because public REITs are so liquid, they have lower yields than private REITs. The simple reasoning:
Given 2 identical REITs, except one is highly liquid, investors will pay more for the liquid one because it gives them more options if they want to sell. This pushes up the share price, meaning the yield (dividends/share price) goes down.
This hurts investors who are investing in real estate for the long run! Investors looking to get into real estate for a multi-year period get hurt because they’re paying extra for liquidity they aren’t even going to use!
Finally, since public REITs are traded on the stock market, they tend to be more correlated with stocks than other types of REITs. Sometimes the share price of a public REIT goes down with the stock market even though nothing has changed about the quality of the REIT’s holdings. Fluctuations in short and long term interest rates may also have a dramatic effect on a REIT’s share price.
Private REITs are almost the exact opposite of public REITs. These companies don’t register with the SEC, so there is little to no public information or transparency about the investment.
The bigger issue is that you probably can’t even invest in private REITs. These investments are only open to accredited investors. That means you need to have a high enough income or net worth to even be allowed to invest in a private REIT.
Private REITs are private for a reason. Even if you’re accredited, you may not be able to invest. Private REITs can only market their investment to investors that they already have a pre-existing relationship with. These REITs can be selective on who their investors are.
Rules for the investment are different for each REIT, but often there is a high minimum (multi-thousands of dollars) for these investments.
Because private REITs aren’t traded on the market, there’s little to no liquidity. Each fund has different rules on when you can sell your shares. If funds allow for early share redemptions, there’s usually a penalty.
On the plus side, private REITs are able to get higher returns than public REITs. Historically, private real estate deals get a cash return of 6.6% vs 5.5% for public real estate.3 Private REITs don’t need to worry about share redemptions so they’re able to invest your money more efficiently.
To recap: private REITs are a great option for high returns. The problem is it’s only an option if you’re already wealthy AND if you can get invited to invest. And then you have to make a large investment.
The final type of REIT is a public non-traded REIT. They’re a hybrid of private and public REITs, combining some of the best features of both.
Like public REITs, public non-traded REITs are available to EVERYONE. There are no income or net worth restrictions for investors. They also register with the SEC, publish their financial information, and have audit requirements.
Even though these REITs have public financials, they don’t have publicly trading shares. Like private REITs, public non-traded REITs don’t have daily liquidity. They’re able to achieve higher returns like private REITs because they have a longer term focus.
Public non-traded REITs are the perfect hybrid because they combine the accessibility of public REITs with the higher returns of private REITs.
Rental properties on Arrived are all structured as public non-traded REITs. Anyone can invest and get access to higher cash returns than they might find on the public market. There are no limitations on who can invest in Arrived’s homes, and our minimum investment is only $100. Like a public REIT, our information is all audited and publicly available for anyone interested in learning more.
|Public REIT||Private REIT||Public Non-Traded REIT (Arrived)|
|Accessibility/Who can invest||High/Anyone||Low/Accredited investors only||High/Anyone|
|Correlation with Stock Market||Medium||Low||Low|
REITs have two huge tax benefits that make all of the complications worth it. Both tax breaks benefit you, the investor! After all, by buying shares in a REIT you are becoming an owner of that rental property, and these tax benefits help you keep more of your hard earned money.
REITs are what’s known as a “passthrough entity”. They pass the income they earn directly to their shareholders. The rental property earns income, which flows through to the owners (you!) and is then taxed as ordinary income.
This is not how large corporations work. If you own stock in a corporation, your dividends are actually taxed twice!
Corporations earn income from their operations. Then the corporation files their tax return and has to pay income taxes to the government.
Then the company takes their leftover earnings and gives some back to shareholders as dividends. The shareholders have to report the dividends and they pay personal income taxes on it.
So the company pays taxes and then the individual pays taxes again – on the same earnings!
REITs are specifically exempted from double-taxation. As long as they abide by the requirements and qualify as a REIT, they don’t pay the corporate income tax. That means they pass more of the earnings on to the shareholders.
For a more in-depth explanation and an example of how this works, see our article on Single Taxation.
Qualified Business Income
For nearly 60 years, the only tax benefit of REITs was avoiding double taxation. However, starting in 2018, a new rule really helps REIT investors.
The 2017 Tax Cuts and Jobs Act shook up a lot of the existing tax code. Among the changes was the creation of the Qualified Business Income deduction. Right now it’s set to last until 2025, but Congress may extend it in the future.
This deduction is only available to owners of a passthrough business. Fortunately, REITs like Arrived are all purposefully structured as a passthrough entity!
This new rule allows investors to deduct up to 20% of their taxable income from REITs! For example, if you earned $100 in dividends from Arrived, you would be taxed as if you only earned $80. You essentially get to keep 20% of your qualified Arrived dividends income-tax free!
That has the effect of lowering each of the tax brackets by 20%. Here’s how the marginal tax brackets change.
If you fall in the tax bracket on the left, your dividends from Arrived are taxed at the marginal rate on the right for the federal income tax.
For a more in-depth explanation and an example of how this works, see our article on The QBI Deduction.
Requirements to be a REIT
Since REITs have some pretty sweet benefits, there’s tight rules on which companies can qualify. These rules make sure that REITs are doing what they were intended to do: generate cash flow and pass that on to the shareholders.
Here’s a sample of the major rules REITs need to comply with.
- REITs are required to distribute 90% of their taxable income back to the shareholders.
This prevents REITs from hoarding cash. The goal of REITs is to generate cash flow and give that back to the investors!
- 75% of a REITs total assets has to be real estate or cash.
- 75% of gross income has to be from rents, real estate sales, or financing a property.
These rules make sure REITs are actually making their money in real estate. These prevent REITs from being used by bad actors to get the tax benefits while investing in non-real estate ventures.
- REITs must have at least 100 shareholders after their first year.
- REITs cannot have more than 50% of shares held by 5 or fewer individuals.
This makes sure that REITs aren’t controlled by a select few shareholders.
Arrived Homes REIT Status
REITs have been a powerful investment vehicle for 60 years. Across the different types of REITs and investment strategies, they all have access to great tax breaks if they stick to the requirements.
Arrived, structured as a public non-traded REIT, gets to reap the benefits of a public and private REIT structure. With Arrived, investors have access to the returns of a private REIT with the low investment minimums and public transparency of a public REIT.
And because of this structure, investors get to keep more of their cash dividends. Arrived investors benefit from single taxation and the Qualified Business Income deduction to keep more of their investment returns.
Sign up today to Arrived Homes below to start investing in rental properties and start participating in all the benefits that REITs can offer.