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These articles contain tax and planning techniques that should be reviewed by your personal tax adviser to determine if they are appropriate for your particular situation and comply with local law. We are unable to render legal or tax advice to individuals.


Real Estate Investment Trusts

Real Estate Investment Trusts Many individuals are attracted to idea of investing in real estate for benefits of current income or the potential for capital gains. However, direct investment in real estate can require large amounts of capital, as well as, the time and expertise to properly manage real estate properties.

One alternative to direct real estate investment is a real estate investment trust (REIT). REITs allow small investors to share in the both the risks and rewards of real estate investing.

What is a REIT

First authorized by Congress in the 1960’s, an REIT is a company that buys, develops, manages and sells real estate assets. It brings together capital from many individuals specifically to invest in a diversified, professionally managed, portfolio of income real estate, or in real estate related debt, such as mortgages. An REIT can take the form of a trust, association or corporation. Individuals invest in an REIT by purchasing shares, similar to shares of a common stock. Shares of many REITs are publicly traded on major stock exchanges and over the counter markets.

Full time managers conduct the day to day operations of an REIT. If a REIT is successful, shareholders can receive dividend income, from rental income and mortgage interest, and capital gain from the profitable sale of real estate assets.

Individual REITs are able to distinguish themselves by specializing in certain areas. They may focus their investments geographically, by region, state, or even metropolitan area. They may focus on certain property types, such as commercial property. Other REITs choose a broader focus, diversifying their investments over various types of property and mortgage assets or in wider geographical areas.

Investment goals for REITs are much the same as investment in other stocks -- current income distributions and long term appreciation potential.

Types of Real Estate Investment Trusts

REITs are usually classified according to their investment focus and fall into three broad categories.

Equity REIT: Equity REITs, the most common REIT, invest in and directly own and operate income properties. The types of properties are diverse and include residential buildings, retail centers, office buildings, industrial parks, or even self storage centers. Equity REITs are thus responsible for the value of their rental estate assets. Income is generated principally from property rents although, capital gain income is possible if properties are sold at a profit.

Finite life real estate investment trust (FREIT): FREITs are a type of equity REIT which have a stated goal of liquidating the real estate portfolio by a specific date. The primary investment goal of a FREIT is to maximize potential capital gain.

Mortgage REIT: Mortgage REITs deal in investment and ownership of various types of property mortgages. These REITs loan money for mortgages to owners of real estate, or invest in purchasing existing mortgages or mortgage backed securities. However, in some cases REIT funds will back mortgages on new construction. Their income is generated primarily from the interest they earn on the mortgage loans.

Hybrid REIT: As the name suggests, hybrid REITs combine the investment strategies by investing in both direct ownership of real estate, as well as, mortgage loans.

Income Tax Issues

The Internal Revenue Code (IRC) contains a number of conditions which a trust must meet to qualify as a Real Estate Investment Trust. If a corporation complies with IRC provisions it will qualify a pass through entity and gain the certain advantages. A pass through entities, companies whose main function is to pass profits on to investors, are free from taxation at the corporate level.

In order for a corporation to gain the advantages and meet the IRC conditions, it must comply with the following provisions: It must be structured as a corporation, business trust, or similar association. It must be managed by a board of directors or trustees, have a minimum of 100 shareholders, and shares must be fully transferable. No more than 50% of the shares can be held by five of fewer individuals during the last half of each taxable year. An REIT is required to pay dividends of at least 90% of its taxable income to investors. At least 75% of its total investment assets must be in real estate, and derive at least 75% of total of gross income from rents or mortgage interest. Lastly, it must have no more then 20% of its assets consist of stocks in taxable REIT subsidiaries.

If a REIT meets these conditions, the income paid to the shareholders is not taxed twice (as it would be in a regular corporation), but is taxed only once, in the hands of the shareholders.

It is important to note that ordinary income distributions, from sources such as rents and mortgage interest, received are fully taxed to the shareholders as ordinary income. Capital gain distributions, from the profitable sale of real estate investments, is long term gain, regardless of the length of time an individual has owned his or her shares in the REIT. If a shareholder sells his or her shares in REIT, the gain or loss for federal income tax purposes generally depends on how long the shares were owned.

How to Invest

REITs are owned by thousands of individuals, as well as, large institutional investors, both foreign and domestic.

An investor can have direct ownership in REITs. Individuals can invest in a publicly traded REIT by purchasing shares through a stockbroker or other securities-licensed professional, and holding the shares in their own names. Financial planners and investment advisors can help to match the investor’s objectives with an individual REIT.

Investors can also have indirect ownership. Open-end investment companies, known as mutual funds, are an indirect method of REIT ownership. Mutual funds pool the resources of many individuals and offer an investor access to a diversified portfolio of professionally managed securities. Recently, mutual funds that specialize in REITs have emerged, including those with global orientation.

Benefits/Investment Uses of REITs

At times, the cyclical nature of real estate can make investments difficult to sell. One of the major advantages to REIT investment is liquidity -- the ease of liquidation of assets into cash - compared to traditional private real estate ownership. One reason for the liquid nature of REIT investment is that shares, primarily traded on major exchanges, are easier to buy and sell than to buy and sell properties in private markets.

Equity REITs are often sought for their long term appreciation potential and as a hedge against inflation. However, many investors are attracted to mortgage REITs because of the relatively high level of current income; REITs in general tend to provide a current yield greater than long term US Treasury bonds and have advantages over stocks and bonds in terms of dividends.

One of the primary incentives for REIT investment is the low correlation of its value to other financial assets. Many investors view real estate as a separate asset class -- distinct from other financial assets such as stocks or bonds -- and thus value REITs for their diversification benefits.

Another factor that is often attractive to investors is that REITs performance is monitored on a regular basis, by independent directors of the REIT, analysts, auditors, and the business and financial media.

REIT investments avoid double taxation, require no minimum investment, and offer investors current income that is usually stable and often provides an attractive return.

Possible Risks

As with all stocks, there are market risks associated with REITs. The value of shares in publicly traded REITs can fluctuate. As investor who sells shares in a REIT could receive more, or less, than the original purchase price. Factors that can influence market risk include general level of real estate property values, which tend to rise and fall with current market conditions.

As with any business, a factor in successful performance lies with management skill. It is important to evaluate the management team of a REIT.

Another risk is dependant on interest rates. Shares of REITs, especially mortgage REITs, are sensitive to changes in the general level of interest rates. Mortgage REITs respond much like bonds, generally increasing in value as interest rates fall and decreasing in value if interest rates rise.
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