A Well-Rounded Portfolio Might Include REITs

A Well-Rounded Portfolio Might Include REITs Mark Twain said to buy land - they're not making any more of it.

That may still be good advice, even though a most popular way to invest in this finite commodity ' via a real estate investment trust (REIT) ' was shortchanged by the last major tax reform bill, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA).

A REIT uses pooled capital from many investors to manage income property and/or mortgage loans, and is traded on a major exchange just like a stock. So here is an explanation of the tax rules affecting REITS and some ideas about how to make them work to your advantage.

If you invest in REITs, dividends are a big part of the equation. REITs normally pay out 100 percent of their taxable income to shareholders, and even in the low rate environment of 2004 many had yields of 4 to 5 percent. But don't expect to pay JGTRRA's bargain 15 percent tax rate on these dividends. They usually don't qualify because of REITs' special tax treatment.

One reason why Congress lowered the dividend rate for individuals was that dividends were being taxed twice at high rates - once when a corporation paid its income tax and again when you paid yours on dividend distributions. JGTRRA provided a remedy. But REITs, even prior to JGTRRA, received a deduction for the dividends they paid and thus did not owe corporate income taxes. So REITS were not included in JGTRRA's dividend tax cut.

Still, the government has to collect from somebody on that income, and guess what? It's you, and at regular income tax rates of up to 35 percent.

Portfolio manager Michael Weiner of Third Avenue Real Estate Value Fund has about 25 to 30 percent of the portfolio invested in REITs and the balance in real estate operating companies. 'They're in the same business, but real estate operating companies are not forced to pay out dividends, can keep that cash flow, recycle it and reinvest,' says Weiner.

But there are exceptions. In at least two scenarios, REIT dividends are eligible for the 15 percent rate, according to the National Association of Real Estate Investment Trusts (NAREIT). If a REIT receives dividends from non-REIT subsidiaries or from outside investments ' and then passes along that income to you ' the 15 percent rate would apply. Although REITs are required to generate at least 75 percent of their income from commercial real estate holdings, many do make other types of investments as well. In the second case, a REIT may decide to retain its earnings (after paying out dividends) and pay corporate tax on its income. In that case, which the tax code permits, any dividends paid out would be subject to the 15 percent rate.

JGTRRA also gave investors a break on capital gains taxes, cutting the top rate from 20 percent to 15 percent. Here, too, REITs can be at a disadvantage. If you sell a REIT stock at a gain after holding it for at least a year, you qualify for the 15 percent rate. That's also true in most cases in which a REIT makes a capital gains distribution. But if the gain is attributable to the recapture of real estate depreciation, the 25 percent tax rate applies. So where do these special rules on REITS leave you?

Since REIT dividends and capital gains may not be taxed as favorably as other investment income, it may make sense to place REITS in a 401(k) plan, IRA or other tax-deferred retirement vehicle. You must examine your total portfolio to see if placing REIT holdings in your retirement plan makes sense.

REITs also have special risks, such as illiquidity and other risks associated with investing in real estate. They are not suitable for all investors. There is also no guarantee a REIT will obtain its objective.

Wherever you hold them, REITs can be effective hedges. Their prices tend not to fluctuate in lock step with stock prices. While past performance does not guarantee future results, and tax considerations are an issue, REITs may add an important component to many portfolios. Be sure to seek the advice of a professional.