How do REITs work?

As of June 30, 2016, about three quarters of publicly traded real estate companies were organized as REITs. This unique corporate structure provides tax considerations that help level the field for shareholders compared with investors who own real estate directly.

As a result, REITs provide an efficient way for individuals to invest in commercial real estate and benefit from the rental income generated by the properties. To qualify as a REIT, companies must follow specific rules defined by legislation in each country. In general, REITs are required to distribute the majority of their taxable net income to shareholders in the form of dividends. REITs must also adhere to certain restrictions on their operations, organization and ownership.

In return, REITs do not have to pay corporate taxes on the net income and capital gains that they distribute, thereby reducing or even eliminating their tax burden. In the U.S., the requirements are as follows:

  • Distribute at least 90% of annual taxable net income (excluding capital gains) via dividends to shareholders. Since income is not taxed at the corporate level, this rule ensures that taxes are still incurred by REIT shareholders. These dividends are taxed as ordinary income.
  • Invest at least 75% of total assets in real estate, mortgage loans or shares in other REITs. Its principal business must be real estate investing.
  • Derive at least 95% of gross income from rents, mortgage interest or gains from the sale of real property. Its principal source of income must be real estate-related.
  • Be managed by a board of directors or trustees. It must maintain a fiduciary responsibility to shareholders.
  • Have shares that are fully transferable, with a minimum of 100 shareholders and no more than 50% of its shares held by five or fewer individuals. It must maintain a broad investor base.
  • Be structured as a taxable corporation. It must be a for-profit company

REITs and Dividends Due to their minimum distribution requirement and cash-flow-oriented business models, REITs have historically offered higher dividend yields than other equities with similar risk profiles.

REITs pay little or no corporate taxes, but must distribute nearly all of their income to shareholders.

Author: Paul McIntyre

Chief Compliance Officer

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