The word is out on REITs. These investments aren't as desirable for your taxable brokerage-firm accounts anymore because of the income tax repercussions. (They're fine for tax-advantaged retirement accounts.) But the word on the street doesn't give you the whole picture.
Strategy: Don't dismiss REITs out of hand. They aren't as tax-disadvantaged as they might initially seem.
What exactly is a REIT (rhymes with "feet")? Short for Real Estate Investment Trust, a REIT is essentially a corporation that invests in real estate properties, much in the same way a mutual fund invests in stocks. And, like a mutual fund, a professional
You can choose from three REIT flavors:
1. Equity REITs invest primarily in income-producing properties. Most of their income is derived from rentals and the property's eventual sale. Equity REITs may concentrate on a particular type of property or a specific geographic area.
2. Mortgage REITs lend money to real estate developers and owners. This financing is the main source of its income.
3. Hybrid REITs combine the elements of both. So, hybrid REITs can take an equity position in the properties that they have financed.
What's the tax problem with REITs? Unlike other corporations, a REIT doesn't have to pay any federal income tax at the entity level if at least 95 percent of its net annual earnings are paid out in dividends. That can give REITs a decided edge over comparable investments. But this advantage turns into a liability when distributions are made to shareholders.
Reason: Thanks to a 2003 tax change, garden-variety dividends are generally taxed at a maximum 15 percent federal rate, just like capital gains. But most REIT dividends don't qualify for the favorable 15 percent rate.
In other words, most REIT dividends are taxed at ordinary income rates that can reach 35 percent!
Good news: Not all REIT payouts are high taxed. In fact, 37 percent of the distributions paid out by REITs in 2004 represent low-taxed capital gain or nontaxable distributions, according to a National Association of Real Estate Investment Trusts (NAREIT) study. That's way up from a decade ago, when just 17 percent of REIT payouts fell into these tax-favored categories.
Remember, tax-rate considerations don't matter for REIT shares you hold in a tax-advantaged account (401(k), Keogh, SEP, variable annuity, etc.).
Here are some REITs that paid out income in 2004 with tax rates lower than ordinary income rates:
• Affordable Residential Communities: www.aboutarc.com
• AvalonBay Communities: www.avalonbay.com
• Duke Realty: www.dukereit.com
• The Town and Country Trust: www.tctrust.com
Source: NAREIT, www.nareit.org