You will recall that, in order to obtain the tax benefits that come with REIT classification, the entity must pay out 90% of its taxable income as dividends. This terminology is a bit of a red herring in that taxable income is distinguishable from the metric “funds from operations”, which is an indicator of ongoing cash flows.
Owners of rental properties typically follow the standard depreciation schedule that is 27.5 years.
Let’s look at a practical example of what that means. If you own a residential unit worth $100,000, with no debt for the sake of simplicity in focusing on the effects of depreciation, that generates $800 per month in rent with no maintenance costs (for the same sake of simplicity), the funds from operations would be $9,600 each year (i.e. the twelve monthly payments of $800). That’s truly the money coming in.
But, since physical objects on land decline over time, depreciation enters the picture to recognize this. When people say “the value of my house went up over the past five years”, what they are precisely saying is that “The value of my land, the dwelling, plus any improvements to the dwelling I’ve made, now exceeds the value of the land and the dwelling of five years ago.”
To adjust for physical deterioration of structures, there is a depreciation table that lets you deduct the decline in the value of the property against your funds from operations. With a $100,000 unit, the first year depreciation is 3.485%. That amounts to $3,485 that gets deduced from the $9,600, so the taxable income is $6,115.
To be eligible for REIT classification, which allows for taxation at the individual shareholder level rather than at both the shareholder level and at the corporate level, the entity must return at least 90% of that $6,115 to shareholders. In other words, even though you brought in $9,600 in rental income, your taxable requirements are measured from a lower base so the 90% here means that $5,503 must be paid as dividends. People make the mistake of only looking to the $6,115 as the rental income or make the mistake of thinking that 90% of that $9,600 base must be paid out. Those are understandable mistakes as one does not usually emerge from the womb with a REIT depreciation calculator.
Those who are truly savvy understand the two major implications of how American tax law interacts with real estate investment trust investing.
First, those assets like AvalonBay, which owns rental properties in Washington D.C., New York, Seattle, and throughout Southern California, benefit from these massive deductions while simultaneously raising rent so they are able to maintain an unusually high amount of retained earnings because their funds from operations can greatly exceed their taxable income.
Second, further taxation can be significantly sidestepped by owning real estate investment trusts in a tax-protected vehicle like a Roth IRA. Just think, there is some guy out there who bought $5,500 worth of Realty Income at $15 per share in 2008 for 366 shares that have since blossomed into 892 shares generating $2.63 each annually, or $2,345.96. You have it within your grasp to go through life collecting $0.42 on every dollar invested within a decade when you combine tax protection with well-chosen REIT investments. Understanding what the 90% tax requirement really means, and where it can and cannot reduce taxes, is an important part of the passive real-estate investing process that is easy to neglect due to its boringness but should not be due to how it can really enhance your compounding.