Doug is an active trader of stocks, bonds, and commodities, as well as an experienced non-fiction writer.
What Is an REIT?
A Real Estate Investment Trust, or REIT, is a company that helps finance real estate with the purpose of producing income. Some REITs also own the real estate properties. REITs are very similar to mutual funds in how they are modeled, because they provide their investors with an income stream with plenty of diversification. REITs pay almost all of the income they receive as dividends to the shareholders. The shareholders respond by paying the income tax attached to those dividends.
REITs are a fantastic way for people to add large-scale real estate properties to their portfolio, the same way they would put their money in other industries through stock purchases. When a stock performs well during a given quarter, the shareholder profits through an increased stock price and/or dividends. The same happens with REITs. IF their investments perform well in a given year, their shareholders benefit.
REITs are traded on major stock exchanges in the same way as regular stocks, but there are also some REITs that are completely private and do not get listed. When referring to REITs, we are usually talking about Equity REITs or Mortgage REITs. Equity REITs are designed to generate income through collecting rent on properties or selling those properties. Mortgage REITs make money by investing in mortgages or mortgage-related securities. The mortgages are linked to both commercial or residential properties.
In today’s economy, REITs play a major role in the economy. They are linked to so many establishments, such as apartments, hospitals, industries, nursing homes, shopping centers, long-term storage locations, housing for college students and much more. Studies by consulting companies show that REITs own properties in every single state in the United States, along with more than 30 different countries around the world.
But how does a company qualify to get classified as a REIT? They must invest a minimum of 75 percent of the assets they own in real estate. In addition, 75 percent or more of their income must come from either the rents earned on their properties, interest in the mortgages they invest in or from the properties they sell.
REITs must also pay 90 percent or more of their taxable income to their shareholders as dividends. They are taxable entities that are managed by either a board of directors or a board of trustees. They must have at least 100 shareholders, and five or fewer shareholders may not have any more than 49 percent of the shares on the market.
What Is an MLP?
A Master Limited Partnership, or MLP, is a form of a limited partnership that gets traded on the stock market. The Masters Limited Partnership has types of partners: limited partners and general partners. Limited partners are responsible for providing capital to the MLP, while they also receive part of the MLP’s cash flow as income distributions. Meanwhile, the general partner is responsible for handling the MLP’s affairs, while their salary is tied to how the entity performs during their stint.
In legal terms, partnerships are defined as an MLP when the partnership gets at least 90 percent of its cash flow from commodities, natural resources or real estate ventures. MLPs are an interesting investment opportunity for individuals because they provide the tax benefits of a limited partnership, while also giving investors the liquidity of buying into a publicly traded company. The tax benefits refer to the fact that the company is not required to pay taxes on the money they make, but dividends received by the unitholders are taxed.
In the United States, MLPs play a huge role in the energy infrastructure of the nation. MLPs are responsible for the transportation, storage and processing of various hydrocarbons, such as oil, natural gas, gas liquids and other refined products. Think of these MLPs as a national highway system, where the cars pay “tolls” whenever they travel from one state to another. MLPs engaged with energy infrastructure make a steady income through the tolls paid by companies that need to transport hydrocarbons from the source to the customer.
What is interesting is the fact that the income generated by MLPs is not necessarily dependent on the prices of oil or natural gas during a given quarter or year. Even when the price of gas becomes really low, the toll on the commodity does not change—because the toll is related to the volume shipped. Another benefit to energy-related MLPs is the built-in inflation hedges within most toll contracts. The toll charged for transporting the hydrocarbons increases after a few years, to keep up with inflation in the nation’s economy.
Investing in REITs
Cheniere Energy Partners LP
Risks of Investing in REITs and MLPs
While both REITs and MLPs differ in the way they are structured, the premise of both is very similar. They pay out a vast majority of their winnings to their shareholders or investors. REITs are legally obligated to provide at least 90 percent of their earnings to shareholders, which means they are left with very little wiggle room during a particular quarter or year. When things are going well, investors may see significant dividends. But if the REIT goes through a bad spell, it could result in a complete bust. And REITs associated with mortgage securities often cut the dividends they pay when interest rates increase or mortgage default rates go up.
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REIT investments are always a risk when the real estate market faces a downturn. It is important for investors putting their money in REITs to have an understanding of how the country’s real estate market is faring. When investing in MLPs, it is important for investors to look beyond high dividends. It is generally recommended to look for MLPs with a long history of having enough cash on hand. These MLPs are far less likely to bust.
Even with REITs, it is a good idea to look at the dividend payout history, because it is more important than one or two years of a 15 or 16 percent dividend yield. Sometimes going with a REIT paying seven or eight percent dividend yield for ten straight years is the way to go, because they have a track record of maintaining their success.
Benefits of REITs
There are a few major reasons why investors may want to put their money in REITs. Diversification is a huge bonus, because REITs often show little correlation to how the stock market is performing. And the dividends paid by REITs are huge, when compared to those paid out by traditional stocks. They are also very easy to buy and sell, which is attractive to investors who may only want to own a REIT for a short period of time.
Statistical analysis has shown that many stock exchange listed REITs outperform the S&P, Dow Jones and NASDAQ. They are also incredibly transparent, because they must follow the same regulatory conditions as other publicly traded companies. Their financial reporting is also identical to a corporate that puts its stocks on the market.
Benefits of MLPs
Most MLPs offer a yield of anywhere from six to seven percent, while they also produce stable and consistent cash flows every year. The cash distributions provided by MLPs are fairly easy to predict, which is great for investors looking for stability. Since MLPs are not burdened by paying taxes, they have a far lower cost of capital than most other companies. MLPs are able to pursue ventures that taxable entities may not deem feasible.
Capital gains is one of the biggest benefits for a company to switch to the MLP structure. Instead of facing double taxation, which is common for corporations, MLPS are only taxed when distributions are received.
MLPs are taxed on the return of capital, while investors must deal with the K-1 tax form when they own MLPs. It is a complicated tax preparation vehicle, but there are plenty of accountants or online tax forms that can help make the process a little less challenging.
Another negative about MLPs is that they do not mesh with IRAs because of UBTI, or the unrelated business taxable income. MLPs often generate this type of income through their operations. If the holdings you have are big enough to result in a UBTI tax bill of over $1,000, you may have to pay taxes on the UBTI, even if the MLP is placed in your tax-deferred account.
But MLPs also come with plenty of tax benefits. Let us sake you bought $100,000 worth of units in a MLP. During the first year, you are given $6,000 in quarterly distributions. When the year ends, you learn these distributions were a total of $6,000 income and $5,000 of depreciation. You would subtract the $5,000 from the $6,000 to get the amount you will pay tax on - $1,000. Even if you are in a very high tax bracket that charges 50 percent tax, you would only end up paying $500 in tax on $6,000 of income.
The tax consequences of MLPs are better understood by looking at return on capital and cost basis. Return on capital is the payment a security, such as REITs or MLPS, makes to an investor from funds not derived from their net income. Cost basis refers to an asset’s original price for tax purposes, adjusted for any dividends or distributions. It is sometimes called the tax basis. When paying taxes, investors can determine their capital gain, which refers to the difference between the cost basis and the current market value of the asset.
With MLPs, you do not have to pay tax right away on your holdings – instead you can deduct them from the cost basis. But if you sell MLP units, you have to pay taxes on the units sold. So holding on to MLPs for the long term makes sense for many investors, because they can wait for their cost basis to reach $0, which means their tax is permanently deferred.
While the prospect of the REIT not being charged tax on their profits is enticing to investors, they must remember that income tax is due on the dividends they receive. In addition, the REIT has to deal with the property tax on their various holdings. For some REITs, property tax can make up as much as 25 percent of operating expenses.
Dividends paid by REITs are taxed as ordinary income to the unitholder. But there are cases where the dividends are considered qualified dividends, which results in a capital gains tax. A vast majority of REIT shareholders will only pay their top marginal tax rate on their dividends. In fact, some of the dividends pay by the REIT may qualify as a nontaxable return of capital, which defers the taxes on those units until they are sold by the owner. Such nontaxable payments end up reducing the cost basis for the unitholder.
Investing in MLPs
There are many ways for investors to put their money in MLPs. One of those ways is through ETF, or Exchange-Traded Fund, MLPs. Exchange-traded funds are marketable securities that track indexes, such as commodities, bonds, or index funds. In contrast to mutual funds, ETFs trade on the stock exchange.
ETF MLPs are a great way for investors to take away some of the business risks associated with buying single MLPS, while also giving them the tax benefits related to exchange-traded funds. But ETF MLPs are often fairly expensive, which is something investors must be wary about.
If investors do not want to take the plunge on ETF MLPs, they can also consider mutual funds that hold MLPs. Mutual funds that invest their money in MLPs will allow investors to delay their tax payments on the distributed income until the investments are sold. These gains qualify as long term gains, which results in a lower tax rate than short-term capital gains.
Mutual funds are also a great option because of their managed nature. Having a mutual fund manager choosing the MLPs to put in the fund can make a huge difference to mitigate the risks of these assets. Far too many investors think all MLPs are created equal. While investors have to pay the maintenance fee for these benefits, it is worthwhile considering the upside.
This article is for information and education only. It is not an endorsement of any particular stock for fund. Consult your stock broker or financial advisor before buying and selling stock.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2016 Doug West