Tax efficiency is a cornerstone to any well-balanced portfolio. To ensure you don’t pay more taxes than you have to, it’s important to consider moving some of your investments out of taxable accounts. This is especially true for real estate investment trusts (REITs).
A REIT is a company that owns, operates or finances income-producing real estate. In doing so, it provides investors with a liquid stake in real estate. Within the REIT sector there are a myriad of sub-categories including hotels, industrial property, offices, residential housing and retail.
However, not every company that operates in real estate is classified as a REIT. To meet this definition, the company must follow several guidelines, including:
- Invest at least 75% of total assets in real estate, cash or U.S. Treasuries.
- Receive a minimum of 75% of its gross income from its property business.
- Pay at least 90% of its taxable income as dividends.
- Be a taxable entity.
- Be managed by a board of directors.
- Have a minimum of 100 shareholders.
- Have no more than half of its shares owned by five or fewer individuals.
Use the Dividend Screener to find high-quality dividend stocks, including REITs by creating a filter like this. You can even screen stocks, including REITs, with DARS ratings above a certain threshold.
REITs and Tax Efficiency
In general, REITs are less effective than other dividend stocks in a taxable portfolio because their payouts represent a large portion of returns. It is the dividend payment and not the share’s growth potential that usually dictates the returns of the asset class. Case in point: since joining the S&P 500 in 2016, the real estate sector and REIT industry have seen dismal growth relative to the broader bull market. In light of these realities, REITs should be held in tax-advantaged accounts.
Check out our dedicated page on REITs here for more information.
There’s another reason to put REITs in tax-advantaged accounts: their dividend tax rate is much higher than dividends on stocks. An analysis of Burton G. Malkiel of Wealthfront found that the dividend tax rate for REITs is 43% compared with 25% for U.S. stocks. This figure was obtained by breaking down the pre-tax expected returns into two categories: capital gains and return from dividends.
Want to invest in physical real estate instead of REITs? Check out this article to learn more.
What’s more, REITs are unlikely to be suitable in taxable accounts so long as their expected return, volatility and correlation remain roughly the same as they are now. REITs are less attractive than U.S. stocks from the perspective of after-tax returns but make up for it by having what’s called differentiated correlation with other asset classes.
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