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By Reuben Gregg Brewer, The Motley Fool
Most people don't have the time or resources to work a regular job and buy investment properties. When they do, it's often in the highly fragmented single-family space, where a landlord may own one or two assets and self-manage the properties.
But that too has now become institutionalized. Real estate investment trusts (REITs) level the playing field. They are even better investments, however, if you know this one tax trick.
Property is nice to own
One of the interesting things about owning an investment property is the cash flow it creates. Cash flow is an important term because an owner gets to depreciate an asset, essentially writing off a little bit of the value of the property each year. That basically allows income to flow to the owner without it being taxed. It's a complicated topic that might require an accountant to get right, but the key here is that directly owning a property has a tax benefit on the income front.
REITs benefit from depreciation too, which is why investors look at funds from operations (FFO) instead of earnings. FFO adds back depreciation, among other things, to better represent a REIT's dividend-paying ability.
However, there's another oddity with REITs that investors need to understand. By design, as long as a REIT pays out 90% of its taxable income as dividends, it avoids corporate-level taxes.
That means more money in the pockets of investors, translating to higher dividend payments and generally higher dividend yields. To put a number on that, the average REIT, using Vanguard Real Estate Index ETF as a proxy, has a yield of 2.2%, while the S&P 500 index has a yield of 1.2%. On an absolute basis, one percentage point may not seem like much, but on a percentage basis, it's a huge 83% difference.
The problem and a solution
There's only one catch: REIT shareholders have to pay taxes on their REIT dividends at their regular rates. Though tax laws change over time, corporate dividends generally get more favorable tax treatment, with lower rates. If you are trying to maximize the income you generate, there's a solution here -- put your REITs in a Roth IRA.
A Roth IRA is funded with after-tax money, meaning you have already paid taxes on the cash you put in. Because of that, Uncle Sam allows you to pull all of the cash out of that account after the age of 65 (and assuming you have owned the account for at least five years), tax free. That's a great deal for most investors, but even more so if you pair it with a REIT.
Let's say you own a high-yield REIT like W.P. Carey (NYSE: WPC), which manages a property-type and geographically diversified portfolio of net lease assets. The REIT's dividend yield is roughly 5.3% today. To keep the math simple, 100 shares of the stock would generate around $423 a year in income. In a taxable account, you'd need to trim that number by your income tax rate, which could be as high as 37% for high earners. That could take as much as $156.50 off W.P. Carey's dividend before it hits your pocket.
But if you put W.P. Carey in a Roth IRA, it avoids that taxation, and you can pull every penny of the dividend out of the account tax free to pay living expenses in retirement. Basically, you've just made REIT dividends even more generous by being careful about the account in which you own them.
Read more: 10 Reasons to Invest in REITs This Year
A little game of chess
The big takeaway here is that you can make a great income investment even better by owning REITs in a Roth IRA because you will effectively avoid all of the taxes you'd otherwise have to pay on their dividends. So, if you have a Roth, you'll want to take a look at it and make sure you put the right investments inside. A good starting point would be to focus on getting REITs into the Roth while putting "normal" corporate stock in a taxable account, so you maximize the tax benefits being offered up by Uncle Sam that let you earn more income from your REITs.
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