What is the 90% rule for REITs?
Even with a challenging market, REITs are considered a staple for many investment portfolios thanks to the 90% rule. As the name implies, this rule stipulates that real estate trusts must distribute 90% of their taxable earnings to existing shareholders.
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
Invest at least 75% of its total assets in real estate. Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Pay at least 90% of its taxable income in the form of shareholder dividends each year.
Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 shareholders (the 100 Shareholder Test) and five or fewer individuals cannot own more than 50% of the value of the REIT's stock during the last half of its taxable year (the 5/50 Test).
To qualify each year as a REIT for IRS purposes, REITs must pay their common and preferred shareholders dividends that equal at least 90 percent of what would otherwise be taxable income. If a REIT pays out only 90 percent of its taxable income, it will owe corporate taxes on the 10 percent it retains.
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. REIT dividends historically have provided: Wealth Accumulation. Reliable Income Returns.
Unlike many companies however, REIT incomes are not taxed at the corporate level. That means REITs avoid the dreaded “double-taxation” of corporate tax and personal income tax. Instead, REITs are sheltered from corporate taxes so their investors are only taxed once.
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.
In situations where all investors submit cash election forms, the dividend payout formula will result in all shareholders receiving their distribution as 20% cash and 80% stock, which means that the cash/stock dividend strategy functions analogously to a pro rata cash dividend coupled with a pro rata stock split.
If less than 75% of the REIT's income for the taxable year is real estate related (known as the 75% gross income test, IRCаза856(c)(3)), it can lose REIT status and cannot elect again to be treated as a REIT for five years (IRCаза856(g)).
What is the 2 year rule for REITs?
IRS safe harbor rules provide relief in situations where a REIT might engage in a prohibited transaction if REIT compliance is not met. To ensure these rules are satisfied: The property held to produce rental income must remain in the REIT for at least two years.
It's important to note that five or fewer investors can't own more than 50% of the shares in a REIT or it will be taxed as a personal holding company.
“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio. Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any.
- Cap rates (Net operating income / property value)
- Equity value / FFO.
- Equity value / AFFO.
Market risk
Real estate investment trusts are traded on major stock exchanges and are subject to price movements in financial markets. This means that investors may receive less than what they originally paid for if they sell their shares in the public exchange.
As of Dec. 12, 2023 publicly traded U.S. equity REITs posted a one-year average dividend yield of 4.09 percent. The health care REIT sector recorded the highest one-year average dividend yield among this group, at 5.07 percent, outperforming the broader Dow Jones Equity All REIT Index by 0.98 percentage points.
Are REITs Risky Investments? When investing only in REITs, individuals incur more risk than when they are part of a diversified portfolio. REITs can be sensitive to interest rates and may not be as tax-friendly as other investments.
A stock portfolio focused on dividends can generate $1,000 per month or more in perpetual passive income, Mircea Iosif wrote on Medium. “For example, at a 4% dividend yield, you would need a portfolio worth $300,000.
So, are REITs the magic shortcut to becoming a millionaire? Not quite. But they can be a powerful tool to build your wealth over time, like a slow and steady rocket taking you towards financial freedom. Remember, the key is to invest wisely, do your research, and choose REITs that match your goals and risk tolerance.
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.
Is it OK to hold REITs in a taxable account?
Return of capital and REITs
A REIT's dividend or distribution income is ordinary income if held in a taxable account like an ordinary brokerage account (non-IRAs and non-401(k)s).
That makes them a great source of income. REITs are also a low-cost investment since shares of most REITs trade for less than $100 each. They're passive investments because you don't need to do any work other than research and follow the investment.
“Both public and non-public REIT investments should be considered long-term, and that could mean different things to different folks, but in general, investors who typically invest in REITs look to hold them for a minimum of three years, and some of them could hold them for 10+ years,” Jhangiani explained.
| REIT SUBGROUP | AVERAGE ANNUAL TOTAL RETURN (1994-2023) |
|---|---|
| Retail | 11.2% |
| Office | 10.1% |
| Lodging/Resorts | 9.0% |
| Diversified | 7.9% |
Can You Lose Money on a REIT? As with any investment, there is always a risk of loss. Publicly traded REITs have the particular risk of losing value as interest rates rise, which typically sends investment capital into bonds.
