How do REITs Work?
09/21/2017 | by Matthew Bechard
REITs, or real estate investment trusts, were created by Congress in 1960 to give all individuals the opportunity to benefit from investing in income-producing real estate. REITs allow anyone to own or finance properties the same way they invest in other industries, through the purchase of stock. In the same way shareholders benefit by owning stocks in other corporations, the stockholders of a REIT earn a share of the income produced through real estate investment, without actually having to go out and buy or finance property.
This video provides some insight into what REITs are and how they work. The REIT industry has a diverse profile, which offers many benefits. REITs often are classified in one of two categories: equity REITs or mREITs. Equity REITs own a wide range of property types including offices, shopping centers, hotels, apartments and much more. Equity REITs derive most of their revenue from rent on those properties.
mREITs may finance both residential and commercial properties. mREITs get most of their revenue from interest earned on their investments in mortgages or mortgage-backed securities.
In addition, REITs may be publicly registered with the Securities and Exchange Commission (SEC) and have their shares listed and traded on major stock exchanges. They may be publicly registered with the SEC, but not have their shares listed or traded on major stock exchanges. Or, they may be private companies (not registered with the SEC and not having their shares listed or traded on a stock exchange).
Regardless of the type, REITs operate under a specific set of rules established by Congress. A REIT is an entity that:
• is modeled after mutual funds;
• is treated by the Internal Revenue Code as a corporation;
• must be widely held by shareholders;
• must primarily own or finance real estate; and
• must own its real estate with a longterm investment horizon.
The IRS implements the REIT rules and oversees what qualifies as a REIT. The Internal Revenue Code requires a REIT to adhere to the following essential rules: at least 75 percent of the corporation's income must be earned from real estate as rent, real estate interest or from the sales of real estate assets; at least 75 percent of the corporation's assets must be real estate assets; and at least 95 percent of income must be passive.
REITs are required to distribute at least 90 percent of taxable income annually to shareholders as taxable dividends. In other words, a REIT cannot retain its earnings. Like a mutual fund, a REIT receives a dividends-paid deduction so no tax is paid at the entity level if 100 percent of income is distributed. REIT shareholders pay taxes on dividends at ordinary rates versus the lower qualified rate.
Over time, REITs and the rules and regulations that govern them have evolved to meet the changing needs of the real estate industry and the broader economy. But throughout that process, REITs have remained true to the mission laid out by Congress in 1960: to make the benefits of income-producing real estate accessible to anyone and everyone. And that's still how they work today.