What Is Real Estate Investment Trusts?
A real estate investment trust is a company that owns, operates or finances income-producing real estate and that, by meeting the Internal Revenue Code's tests on assets, income, ownership and distributions (at least 90% of taxable income paid out), pays no corporate income tax on the income it distributes. REITs let investors hold commercial property and mortgages through shares, listed or unlisted, and their dividends are mostly ordinary income with a 20% deduction, which shapes where they belong in a portfolio.
| Item | Detail |
|---|---|
| Tax status | No corporate tax on distributed income if the asset, income, ownership and 90% distribution tests are met |
| Types | Equity REITs (own property), mortgage REITs (hold loans and MBS), hybrids |
| Forms | Publicly traded on exchanges; public non-traded (registered, unlisted); private (unregistered) |
| Sectors | Apartments, offices, industrial, retail, data centers, cell towers, healthcare, self-storage, hotels, timber, farmland |
| Dividends | Mostly ordinary income eligible for the 20% section 199A deduction; portions can be capital gain or return of capital |
| Guidance | Investor.gov's REIT page and the SEC's REIT investor bulletin |
How Does Real Estate Investment Trusts Work?
The REIT raises equity and debt, buys or develops property, leases it to tenants and distributes most of the rental income as dividends; because the distributions are deducted at the REIT level, the income is taxed once, at the shareholder. Listed REITs trade like stocks, with prices that move with rates, property fundamentals and the equity market; non-traded and private REITs are valued periodically by their sponsors and redeemed, if at all, under limits. Investor.gov's REIT page and the SEC's investor bulletin describe the three forms and their differences in liquidity, fees and transparency, and the bulletin's warnings about non-traded REIT distributions funded by borrowing or offering proceeds are the standard ones. Mortgage REITs hold loans and mortgage securities funded with repo, which makes them a leveraged rate play rather than a property investment. The 90% payout rule leaves REITs dependent on capital markets for growth, so they issue shares and debt regularly, and their dividends, taxed as ordinary income with the 20% deduction, are usually best held in tax-deferred accounts.
Worked example. A $50,000 REIT holding yields 4.5%, $2,250 a year, of which 80% is ordinary income and the rest return of capital. For a holder in the 32% bracket, the ordinary portion is taxed after the 20% section 199A deduction at an effective 25.6%, $461 a year, against $338 if the same $2,250 were qualified dividends at 15%. In an IRA the tax is deferred entirely, which is why REITs are the standard example of an asset to hold in tax-advantaged accounts. The inputs are illustrative numbers, not market data.
What Does Real Estate Investment Trusts Cost?
Brokerage commissions and spreads for listed REITs; expense ratios of 0.1% to 0.5% for REIT funds and ETFs; for non-traded REITs, selling commissions and fees that have historically consumed 10% or more of the offering price, plus ongoing advisory fees; for private REITs, sponsor fees and promoted interests.
How Is Real Estate Investment Trusts Taxed?
Dividends are reported on Form 1099-DIV in three parts: ordinary income (eligible for the 20% qualified business income deduction under section 199A), capital gain distributions and return of capital, which reduces basis. REIT dividends are not qualified dividends. Sales produce capital gain or loss. IRS Topic 404 and Publication 550 cover the reporting; the SEC bulletin and Investor.gov describe the forms.
What Are the Risks of Real Estate Investment Trusts?
- Interest rates: REIT prices fall when rates rise, both through capitalization rates and through competition from bond yields.
- Property fundamentals: vacancy, rent declines and obsolescence by sector, with office the recent example.
- Leverage and capital dependence: the 90% payout rule means growth is financed externally, and debt must be refinanced.
- Form-specific risks: non-traded and private REITs add illiquidity, high fees and valuation opacity.
Common misconception. A REIT is not a bond with a property behind it. Listed REITs have equity volatility and fell by more than half in 2008 and by a third in March 2020; their yields are higher than stocks' because they must distribute, not because they are safer, and the income is taxed less favourably than qualified dividends. They are an equity allocation to real estate, and the dividend is the form of the return, not a cushion.
Where Does Real Estate Investment Trusts Fit?
Liquidity. Excellent for listed REITs and REIT funds; poor for non-traded REITs (redemption programs with limits that have been suspended in stress) and private REITs.
Who uses it. Investors who want real estate exposure with daily liquidity and professional management, preferably in tax-deferred accounts; non-traded and private REITs only for those who have read the fee tables and accept illiquidity.
Portfolio role. The real estate component of an equity allocation, typically 5% to 15% of a diversified portfolio, held in tax-advantaged accounts where possible; listed REITs and funds are the default, with the other forms a deliberate choice.