REIT: Real Estate, Forming, Advantages / Disadvantages & Taxes

REITS – Real Estate Investment Trusts are forms of real estate ownership which allow investors to invest in a large portfolio of real estate investments. There are advantages and disadvantages, as well as potential risks of investing in REITs. REITs are basically investing in real estate stocks. Taxation, how to form a REIT, ways to profit from REIT, and more are discussed in this how-to guide on the steps which will make you invest your capital wisely into real estate trusts.

REIT: Formation, Advantages and Disadvantages

For a more grand style of investment. It is possible to have a trust which manages real estate investments, in which many shareholders invest much capital. These are the wall street version of a real estate holding, and are connected with massive sums of capital.

Definition and Basics: Real Estate Trust Fund

A REIT is first and foremost a Real-Estate-Investment-Trust. At first glance, a REIT seems very similar to a real estate corporation. It is a company which operates or owns real estate. These are typically income-producing, such as hotels, infrastructure, or warehouse. That means the majority of its economy comes from income, as opposed to in the form of sales or appreciation. REITs are also usually not diversified. A REIT which specializes in timber, will own much land, but very little e.g. office spaces.

  • Real Estate Investment Trust – Publicly traded companies

Forming a REIT: Big Real Estate Company

If you wanto to form a REIT you must first establish a partnership agreement. Typically REITs are originally management companies, thanks to the requirement of 100 investors. Next you decide in which state you will form your REIT, and contact this state’s secretary. Next, the private placement memorandum (also called offering memorandum) details important information about the REIT, e.g. properties which it intends to invest in, and information about board directors. Now you start searching for investors, by offering your prospectus which informs them of your strategies, structure, etc. Once the magic number of 100 is reached, you can filed for articles of incorproation. Finally, you file Form 1120 with the IRS, and you’re done!

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Process summarized:

  1. Establish partnership agreement
  2. Decide on location
  3. Contact secretary of state
  4. Write a private placement memorandum
  5. Investor search using prospectus
  6. File for articles of incorporation and Form 1120

Documents:

  • Private Placement Memorandum (a.k.a. Offering Memorandum)
  • Prospectus
  • Form 1120

Advantages: Low Risk, Diversification and Flexibility

Investors can profit from investments which they would usually not be capable of making. These can be massive infrastructure projects which an everyday person typically does not have the money to invest in, but in cooperation with many others can contribute. Additionally, they are able to diversify their investment within the real estate market, because they hold an interest in multiple properties with minimal dollars. There is also lower risk associated with REIT investing. Another certain advantage is the fact that investors can sell their shares quickly. Another advantage, if you are a foreign national in the USA, is that, although you would not qualify to invest in traditional real estate, you can through a REIT.

  • Profit from investments which would otherwise be impossible
  • Diversified investments
  • Lower risk
  • Sell shares quickly
  • Not barred if foreign

Disadvantages: Slow, Taxation and Loss of Control

Some disadvantages were mentioned earlier. The main disadvantage is that REITs are typically not subject to large growth because they cannot reinvest their income. They are forced to return 90% of the earnings to the investors meaning only 10% of the earnings can be reinvested in the company. Additionally, while most dividends are only taxed at 15%, REIT dividends are taxed as regular income. This is a much higher rate. There is also the drawback that REIT investors do not have control over operational decisions, meaning they can be helpless against ineffective changes. Lastly, some REITs (but not all, do your research!) incur exorbitant management and transaction fees. This logically leads to lower distributions of incomme to shareholders, and therefore reduced income for the investors.

  • Slow growth
  • Dividends highly taxed
  • No control over operational decisions
  • High management & transaction fees

Real Estate REIT: Requirements, Profit

If you want to get in on the REIT business, there’s a few things to keep in mind. If you own property, or want to buy and sell properties, a REIT will not be for you. It is a more likely choice when you have surplus capital which you want to invest in a slow-growing and safe trust.

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Are REITs Publicly Traded?

Yes! This makes the fundamental difference between other LLCs or e.g. limited partnerships. They are publicly traded, and therefore you can invest in REITs as you would in other trusts or stocks. In a sense they are stocks where you invest in real estate managers.

  • Yes, REITs are publicly traded

Can I Start my own REIT? Requirements

Yes! Although it is not easy. There are a few important things to keep in mind. First, before becoming a REIT, most companies are LLCs, which once finding enough investors, file to become a REIT. These requirements are not asked to be present in the first year of a REITs operation, but usually by the second.

  • REITs have multiple requirements
  • Most REITs begin as LLCs

How Many Investors in a REIT?

The first important requirement is that you must have at least 100 investors. For most people it is difficult to find this. Especially when having little real estate experience, it is hard to find this many investors willing to take the risk.

  • At least 100

Pay-Out for REITs – Over 90% of Profit

REITs must, by law, be structured such that at least 90% of profits must be distributed to investors as dividends, every single year. This is a law, and therefore, once not doing this, a REIT will forfeit its status as such and no longer qualify for the additional benefits of being a REIT.

  • REITs must distribute at least 90% of profits to investors

What does a REIT Invest in?

Another law from the IRS: you must also invest at least 75 percent of a REITs value/assets in a form of real estate. This is usually not a problem, with the majority of REITs having over 90% of their assets invested in real estate. A REIT must also derive at least 95 percent of its gross income from real estate investments.

  • REITs must invest at least 75% of their assets in real estate

Can you Become Rich with REITs? – Profit, Investment Dividends

Most people will not become rich with REITs. They are slow to throw dividends, yet for that reason usually very safe. It is unlikely to e.g. double your investment. Yet, in the long run, the vast majority of REITs have outperformed most stocks, meaning that they are a safer investment. Although there are some mega-REITs which have shown massive increases in value, and great profit for their investors, these are not get-rich-quick stocks.

  • REITs are a safe but slow-growing investment
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Invest in Real Estate or REITs? How to Choose

If you’re struggling to decide whether to invest in a REIT or in real life real estate? Take a look below, as this video explains everything you need to know about REITs and real estate:

Can an LLC be a REIT? Differences and Similarities

First and foremost, REITs are taxed as corporations. In practice, this means that most management companies intending to become a REIT will begin their life as an LLC. Once this LLC has grown to be large enough, it will file to become a REIT.

Taxes: Few Advantages

If you want tax deductions, REITs probably won’t be for you. Compared with traditional real estate investing, where tax write-offs are near-infinite, including depreciation, mortgage, interest, etc., REITs are not as priveliged.

  1. REIT dividends Taxation
  2. Depreciation Expenses

Normal Income – REIT Dividends

At least 90% of income which the REIT generates must be passed on to investors. This is taxed according to each individual investor’s marginal tax rate. In other words, the income which an investor makes from REITs is taxed as any other income would be.

  • Dividends are taxed as normal income by investors

Depreciation Expenses – REIT Tax Advantage

Depreciation expenses can reduce the amount of income received. REIT investors can minimize their taxes by writing off this depreciation on the dividends they receive.

  • You can write off depreciation for REITs

REIT Summary: Big-Time, Slow-Time

REITs certainly have a good reason to exist. They offer a unique opportunity to invest in the massive and seemingly unbeatable real estate market, without having to shell out the millions, or taking up a mortgage. With less risk comes less reward though, and this type of investment is not likely to pay off quickly or heavily. It is a small and constant pay-off. This can be attractive or not depending on what you prefer!