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As Generation X and millennials inherit their baby boomer parents’ assets amid the so-called Great Wealth Transfer, some will look to invest it in rental property to generate income.
This property might be a duplex, an apartment building or, depending on the location, a single-family house that could eventually become a retirement home.
Yet many aren’t aware that because of the various costs and risks involved, becoming a landlord — a role fraught with headaches — may not turn out to be profitable.
A hands-off alternative to direct real estate investment is a real estate investment trust. These firms sell shares to investors, use the cash to buy residential, commercial and industrial property to lease out, and pay dividends to shareholders.
As an investment, REITs have long had advantages over owning property directly. This advantage gap is widened by new federal tax rules.
A somewhat overlooked provision of the tax law that went into effect last year allows individuals hefty deductions on REIT income. Investors filing jointly with taxable income of less than $315,000 — and those filing individually with taxable income of $157,000 — are eligible for a 20% deduction. Investors with higher taxable income — up to $415,000 filing jointly and $207,000, individually—are eligible for deductions on a reduced scale.
While the tax legislation makes REITs more attractive, it perhaps makes direct real estate investment less so. A provision that’s received widespread attention is the new $10,000 cap on the itemized deduction of state and local taxes, much is which is from property tax.
This has caused consternation aplenty in regions where high property values have long resulted in substantial deductions for homeowners. For investors in residential real estate, especially in expensive areas, this new provision is paring post-tax profits.
The tax legislation also reduces the maximum allowable amount of the purchase price for mortgage interest deductions from $1 million properties to those selling for $750,000.
These changes, along with the new deductions on REIT income, can mean improved net returns from investing in REIT shares as opposed to direct property ownership. Moreover, the new tax law includes business-tax changes beneficial to REITs and, ultimately, to their investors.
Most REITs are publicly traded like stocks, making them highly liquid — unlike most real estate investments.
Like stocks, they’re bought and sold on major exchanges throughout the trading day. Some REITs own property used for a variety of purposes, but most specialize, variously owning real estate used for apartment buildings, health-care facilities, hotels, shopping malls, commercial office parks and industrial property for factories, on-line retailing fulfillment centers and server farms.
As some REITs can be highly specialized (such as cell phone towers), selecting them for investment should come after considerable analysis of specialized markets. REITs are considered an alternative asset — one that can diversify portfolios composed of traditional assets, such as stocks and bonds.
To qualify as a REIT under federal rules, entities must pay a minimum of 90% of its profits to shareholders in distributions. Part of this income is in the form of taxable dividends. The rest is return of capital, which is tax-deferred.
Many who invest in rental property focus on potential income from rents without fully considering the other side of the financial equation — the various expenses involved. These include maintenance, taxes, insurance and attorneys’ fees for evictions. Nor do these investors consider the risks, including liability to tenants, unpaid rents and property damage.
Moreover, many direct real estate investors assume that values will rise over time, but this is by no means guaranteed. And even if this happens, the gain before sale might not be enough to compensate for a potential disparity between long-term income and cumulative costs. In this scenario, contrary to what the investor expected, there would be no long-term profit.
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By contrast, well-managed REITs pay fairly reliable dividends.
However, they can encounter problems resulting in losses being passed on to investors in the form of pummeled share value. For example, if an apartment-building REIT overestimates demand and rent levels, the REIT owning it could end up losing money on the investment, at least in the short term. But residential REITs tend to own portfolios of real estate purchased at different times.
In the headache category, there’s no comparison. REIT investments enable shareholders to avoid “landlord stress,” be it late night calls about broken furnaces, roof leaks … you name it.
— By David Robinson, founder and CEO of RTS Private Wealth Management