Real estate investment trusts (REITs) have established themselves as a means for the smaller investor to directly participate in the higher returns generated by real estateproperties. In the past, these trusts were considered to be minor offshoots of unit investment trusts, in the same category as energy or other sector-related trusts that had been created, but when the Global Industry Classification Standard granted REITs the status of being a separate asset class the rules changed and their popularity soared.
In this article, we will explain how REITs work and then examine the unique tax implications and savings they offer to regular investors. (To begin with an overview of these assets and what they can do for your portfolio, see The REIT Way.)
Basic Characteristics of REITs
REITs are a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts. Each unit in an REIT represents a proportionate fraction of ownership in each of the underlying properties. REITs on the NYSE possess a market cap of $423 billion. In 2011, nearly 140 REITs were traded actively on the New York Stock Exchange and other markets.
SEE: Exploring Real Estate Investments
Typically, REITs tend to be more value than growth-oriented, and are chiefly composed of small and mid cap holdings.
The IRS requires REITs to pay out at least 90% of their incomes to unitholders (the equivalent of shareholders). This is similar to corporations, and means REITs provide higher yields than those typically found in the traditional fixed-income markets. They also tend to be less volatile than traditional stocks because they swing with the real estate market. (To learn about REIT valuation, see Basic Valuation Of A Real Estate Investment Trust.)
Three Types of REITs
REITs can be broken down into three categories: equity REITs, mortgage REITs and hybrid REITs.
Taxation at the Trust Level
REITs must follow the same rules as all other unit investment trusts. This means that REITs must be taxed first at the trust level, then to beneficiaries. But they must follow the same method of self assessment as corporations. So, REITs have the same valuation and accounting rules as corporations, but instead of passing through profits, they pass cash flow directly to unitholders.
For all practical purposes, REITs are generally exempt from taxation at the trust level as long they distribute at least 90% of their income to their unit holders. However, even REITs that adhere to this rule still face corporate taxation on any retained income.
Taxation to UnitholdersThe dividend payments made out by the REIT are taxed to the unitholder as ordinary income - unless they are considered to be "qualified dividends", which are taxed as capital gains. Otherwise, the dividend will be taxed at the unitholder's top marginal tax rate.
Also, a portion of the dividends paid by REITs may constitute a nontaxable return of capital, which not only reduces the unit holder's taxable income in the year the dividend is received, but also defers taxes on that portion until the capital asset is sold. These payments also reduce the cost basis for the unitholder. The nontaxable portions are then taxed as either long- or short-term capital gains/losses.
Because REITs are seldom taxed at the trust level, they can offer relatively higher yields than stocks, whose issuers must pay taxes at the corporate level before computing dividend payout.
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Example - Unitholder Tax Calculation
Jennifer decides to invest in an REIT that is currently trading at $20 per unit. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholders. However, $0.60 per unit of this dividend comes from depreciation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($1.80 - $0.60) of this dividend comes from actual earnings.
This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by $0.60 to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a long- or short-term gain/loss when the units are sold.
The Bottom Line
The unique tax advantages offered by REITs can translate into superior yields for investors seeking higher returns with relative stability. Theoretically, it is possible for a unitholder to achieve a negative cost basis if the units are held for a long enough period of time. While this is hardly common, the potential for realizing a possible gain or loss in this manner should be clearly understood by investors.
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Dividend Stock Strategies
You see, aside from the paycheck Buffett received from his "day job," Warren earned an estimated $42,583,971 in income last year from the dividends spun off from his own personal holdings.
Those dividend money machines accounted for 99.76% of his estimated 2009 income, keeping him flush with cheeseburgers and business jets.
And with the yields on the benchmark 10-year Treasury note hovering in the 3.8% range and the market struggling to rebound, Buffett's dividend portfolio will likely outperform in 2010, adding to his massive fortune.
True to form, he buys them, holds them, and watches them grow. Simple — but effective.
But that is not the only advantage to be had by building a portfolio like Warren's. The other benefits of a divided-based portfolio include:
Safety - If preserving your money is as important to you as it is to Buffett, dividend investments are preferable because of their low risk.
Diversification - If the balance of your portfolio tilts towards growth, dividend investments can help you diversify acting as buffer against unpredictable market swings.
Access - Dividend-paying stocks offer investors ready access to their income streams, unlike similar investments in 401(k)s and IRAs, which are retirement based and carry penalties for early withdraws.
So don't believe for a second that income investments are boring and are only suited for the gray-haired crowd. The larger truth is that dividend-paying stocks should be a part of every well-balanced portfolio — young, old, or somewhere in between.
Here's why...
Even in bear markets, dividend-paying stocks typically do well, especially if those companies have a strong history of increasing the dividend payout.
That's because investors win two ways when a company increases its dividend. First, the yield on your initial investment goes up with the dividend; second, and even better, the dividend increase often propels the share price higher.
That's an unbeatable combination in today's tough markets. And it's the reason that investors are so eager right now to gobble up companies with solid dividend yields.
So What is Dividend Yield?
In short, a dividend yield is a cash payout that you receive for simply being a shareholder, sort of like receiving a bonus based on a company's earnings.
Moreover, these "bonuses" also offer lower tax rates than similar investments in savings, CDs, or money market accounts. Thanks to a change in the tax law, dividends are now taxed at only 15%. That's considerably better than the 35%+ taxation levied against ordinary income. (Even though these tax changes may eventually be eliminated.)
Dividend yield is simply your rate of return from the dividend payouts, exclusive of any stock price appreciation. It's calculated by dividing the dividends you receive over a year's time by the price you paid for the stock.
I'll give you an example: Your dividend yield is 5% if you paid $20 per share, and you receive $1 per share in dividends ($1/$20) over the 12 months following your purchase.
Dividend yield, however, is not a fixed number. It changes along with the share price. For instance, say someone else buys the same stock a week later when the share price had moved up to $25. Instead of 5%, their dividend yield would only be 4% ($1/$25).
However, as Warren Buffett would surely tell you, picking successful dividend-paying stocks is not as simple as buying the stocks with the highest yields. In fact, the stocks with the highest yields often trip up investors the most.
So if you really want to invest like Warren Buffett, you can spend your time pouring over his annual letter to shareholders, or you can create a dividend money machine of your own by following the famed investor's own personal holdings.
Since January 1, 2009, Canadian residents who are 18 years of age or older with a valid SIN are eligible to contribute up to $5,000 annually to a TFSA.
Note
You cannot contribute more than your TFSA contribution room in a given year, even if you make withdrawals from the account during the year. Withdrawals from the account in the year will be reflected in your contribution room in the following year. If you over-contribute in the year, you will be subject to a tax equal to 1% of the highest excess TFSA amount in the month, for each month you are in an excess contribution position.
Investment income earned by, and/or changes in the value of TFSA investments will not affect your TFSA contribution room for the current or future years. For an example, seeExample 1 - TFSA contribution room.
TFSA contribution room accumulates every year, if at any time in the calendar year you are 18 years of age or older and a resident of Canada. You do not have to set up a TFSA or file a tax return to earn contribution room.
If, for example, an individual who is 18 years or older in 2009 is not obligated to file a tax return until 2016, they would be considered to have accumulated TFSA contribution room for each year starting in 2009.
An individual will not accumulate TFSA contribution room for any year during which the individual is a non-resident of Canada throughout the entire year.
The TFSA dollar limit is not prorated in the year an individual:
The $5,000 TFSA dollar limit is indexed based on the inflation rate. The indexed amount will be rounded to the nearest $500. For example, assuming that the inflation rate is 2% for 2010 and 2011, the TFSA dollar limit would be $5,000 for 2010 and 2011.
The TFSA contribution room is made up of:
Note
You can have more than one TFSA at any given time, as long as the total amount contributed to all your TFSAs during a year is not more than your available TFSA contribution room for that year. As the account holder, you are the only person who can contribute to your TFSA.
Your TFSA contribution room information can be found on your latest notice of assessment or notice of reassessment or by going to one of the following services:
You should keep records about your TFSA transactions to ensure that you do not exceed your TFSA contribution room. The CRA will also keep track of your contribution room and determine the balance of room at a particular time for each eligible individual based on information provided by you and the TFSA issuers.
However, if at the time we issue your notice of assessment or your notice of reassessment, we have not received or finished processing the information from your TFSA issuer(s), the amount indicated may not reflect the most up-to-date amount. You should verify the amount indicated on your notice of assessment or your notice of reassessment to make sure it corresponds to your records. Contact us if you notice any discrepancies.
If you are not required to file an income tax return for the year, and decide not to do so, you will not receive a notice of assessment showing your TFSA contribution room. In thatcase, you should keep track of your available TFSA contribution room to ensure that your contributions do not exceed your limit.
In addition to advising you of your unused TFSA contribution room on your notice of assessment (after you file an income tax and benefit return), the CRA may also send aTFSA Room Statement, later in the year, if the calculated amount of your unused TFSA contribution room has changed from the previously stated amount. A TFSA Transaction Summary of your contribution and withdrawal details as received from your TFSA issuer(s) will be available on request.
If you disagree with any of the information on your TFSA Room Statement, or TFSA Transaction Summary, such as dates or amounts of contributions or withdrawals which your TFSA issuer has provided to the CRA, you should contact your TFSA issuer. If any information initially provided by the issuer regarding your account is incorrect, the issuer must send us an amended information return so that we can update our records.