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0:28 - What is a REIT?
2:08 - Reit dividends breakdown
4:14 - How to invest in reits

You've probably heard the term REIT but may not know what it is. Real estate investment trusts, or REITs, can be fantastic ways to add both growth and income to your overall portfolio, while adding diversification at the same time.

A real estate investment trust, or REIT, is a unique type of company that allows investors to pool their money to invest in real estate assets.

There are some specific requirements that must be met.

REITs must invest at least three-fourths of their assets in real estate or related assets, and must derive three-fourths of their income (or more) from these assets.

REITs must be structured as corporations, and they must have at least 100 shareholders. Because of the 100-shareholder requirement, many REITs start out as real estate partnerships, and the become REITs later on.

No more than 50% of a REIT’s shares can be owned by five or fewer shareholders. In general, REITs limit the ownership of any single investor to 10% in order to ensure compliance with this rule.

Most importantly to you as an investor, REITs are required to pay out at least 90% of their taxable income. This is why REITs typically pay above-average dividend yields.

You’re probably wondering -- why would a company want to be classified as a REIT?

REITs are not treated as ordinary corporations for tax purposes. If a company qualifies as a REIT, it will pay no corporate tax whatsoever, no matter how much profit it earns.

This is where the 90% payout requirement comes in. Because REITs are required to pay out most of their income, they are treated as pass-through entities and are only taxable at the individual level.

The two main types of REITs

Before we go any further, let’s take a minute to discuss the two different classifications of REITs. There are REITs that specialize in a wide variety of asset types, but all REITs can be dropped into one of two buckets: mortgage REITs and equity REITs.

First, equity REITs are the type of real estate investment trusts that own properties as their primary business. For example, a shopping mall REIT or a senior housing REIT would be considered an equity REIT. In general, you can assume the term REIT refers to equity REITs unless specified otherwise.

Second, mortgage REITs invest in mortgages, mortgage-backed securities, and other mortgage-related assets. This means they aren't usually invested in physical assets but in the loans surrounding those assets.

Now that we know a little more about the types of REITs, let's discuss how you evaluate a potential REIT investment.

There are two very important metrics for real estate investors to know.

The two most important metrics to know are funds from operations (FFO) and company-specific varieties of that same metric.

Funds from operations, or FFO, expresses a company’s profits in a way that makes more sense for REITs than traditional metrics like “net income" or "earnings per share."

When you invest in real estate, you can write off (deduct) a certain portion of the purchase price each year. This is known as depreciation and it's something that rental property investors are probably familiar with.

Although this decreases taxable income, it also distorts a REIT’s profits -- after all, depreciation doesn’t actually cost the REIT anything. FFO adds back in this depreciation expense, makes a few other adjustments, and creates a real-estate-friendly expression of a company’s profits.

The price-to-FFO ratio is a way to assess whether a REIT is expensive or cheap relative to its peers.

Tax implications of REIT investing

First off, most REIT dividends don’t meet the IRS definition of "qualified dividends," which would entitle them to lower tax rates. For example, someone in the 22% tax bracket typically pays 15% on qualified dividends, but REIT dividends generally don’t qualify for this favorable treatment.

However, because REITs are pass-through businesses, REIT dividends that aren’t considered qualified dividends typically qualify for the 20% qualified business income (QBI) deduction. In other words, if you receive $1,000 in ordinary dividends from a REIT, as little as $800 of that amount could be taxable.

When you receive your year-end tax forms from your brokerage, the dividend classification will be broken down for you automatically which makes it a lot easier to deal with at tax time.

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