So you want to get into real estate investing? The good news is you don’t need to be a pro to get started. Opportunities abound for new investors looking to get experience and work toward increasing their wealth. You don’t need to be a millionaire to take advantage of these investments. You just need some capital and a plan for how to make it work for you.

One of the best-kept secrets for maximizing your investment is to create a tax plan. Without one, you might find that more of your returns are going to the IRS than your savings account. Part of your tax planning will involve deciding on a legal entity for your real estate holdings. In our last blog, we discussed the pros and cons of common entity types. In today’s blog, we’ll focus on when to consider a real estate investment trust (REIT). 

What is a REIT?
A real estate investment trust owns, operates, or finances income-generating real estate. The company runs by selling shares to raise capital for these investments. The REIT was originally conceived of as a mutual fund for real estate, allowing real estate sellers to create much bigger deals. With a REIT, you can have 150 people pooling their money and going in on a $100 million project that no one person could afford on their own. 

REITs come with some major pros and cons. The downside is that this type of trust faces excessive statutory requirements. Individuals, family offices, and closely held companies cannot directly own an entire REIT. For a REIT to meet its legal definition:

● At least 75% of its assets must consist of real property. This prevents people from trying to take advantage of the benefits of a REIT for other business purposes. 
● At least 85% of its income must be passive income. This makes sense if its primary purpose is to hold real estate.
● It must be widely held with 100 or more shareholders, and five or fewer individuals cannot own 50% or more of the REIT. 
● It must distribute its income among these shareholders.

However, if you do meet the requirements, a REIT provides many of the benefits of being a corporation but also treats it like a pass-through entity. For state law purposes, a REIT is structured as a corporation, but the entity gets a deduction for the dividends that it distributes, which helps offset any corporate level tax. 

The Benefits of a REIT

In a way, joining or creating a REIT is a different way of doing an 1031 exchange. Under section 1031 of the tax code, real estate investors are allowed to do a “like-kind exchange” where they sell an investment property and then immediately reinvest the profits into a new “like-kind” property. This allows investors to sidestep paying capital gains taxes by deferring that bill until they sell the new property. Unlike the limitations of 1031 and what counts as a “like-kind” property, a REIT allows you to invest in more profitable properties and a larger number of properties without bearing the full burden of all the tax consequences. 

REITs also allow newcomers to the world of real estate investing to safely invest in more sophisticated projects. For instance, some REITs may have deals where they might be developing or redeveloping a 50-story condominium tower, a shopping mall, or a similar large commercial property where the risk level and financial commitment would be exponentially higher for an individual investor. With a REIT, you face a much lower risk as an individual—but with the potential for a high reward. 

When to exchange a REIT for an UPREIT

What if you’d like to have more ownership than a traditional REIT allows for? An UPREIT could offer the solution. An Umbrella Partnership Real Estate Investment Trust allows real estate owners to contribute their properties to a REIT in exchange for partnership interests. In other words, you have the structure owning its property assets through a master partnership, and the property owner contributes to that master partnership. With an UPREIT, individuals can function as a joint venture partner with a REIT and receive the benefits, including diversifying their investment so they don’t just own the one property. Contributing a property to an UPREIT can also help you delay and avoid tax on an appreciated property.

How do you know if an UPREIT could be a good option for you? Consider, what are your plans for the money once you sell the property? Are you looking to pocket and use the cash right now, or would you be more interested in reinvesting and increasing your cash flow over time through a commercial property? If it’s the latter, an UPREIT could be the solution. Again, by contributing the property, you’re deferring the tax you’d owe by selling it outright. You’re essentially diluting your ownership of the property and expanding your investment into a bigger portfolio of properties. Then once you’re a partner in the UPREIT, you can enjoy the regular profit distributions. For a taxpayer who is transitioning into retirement and looking for strong cash flow, a REIT could provide that. 

Could a REIT or an UPREIT be right for you? Knowing the pros and cons of these and any other entity types will help you determine which one is best for your tax situation—that and the help of a qualified professional. For assistance setting up a tax plan for your real estate investments., reach out to a Certified Tax Planner today. 

Don’t miss the rest of our 4 part Real Estate Investment series!