Do you want to invest in real estate with limited capital? REIT can help in this case. Here is a detailed guide for beginners on passive income with REITs.
When it comes to passive income, real estate investment is as passive as it gets.
But, if you acquire your own properties, you’ll be dealing with stuff like maintenance, horrible tenants, and legal documentation, which can get quite frustrating over time.
However, if you consider investing in REITs, you can avoid these hassles while earning a passive income on your investment.
It sounds almost too good to be true, right? If you’re apprehensive about stepping into REIT passive income, here’s everything you need to know about the investment technique to make an informed decision.
Should You Invest in Real Estate?
Some ways you can invest in real estate involve more risk than others. Your options will depend on your level of capital available, time availability, investment time horizon, among other factors.
Ownership can range from direct ownership and management to direct ownership with a third-party property manager, short-term rentals, real estate investment trusts (REITs), purchasing mortgage-backed securities, crowdsourced ownership, mobile home parks, site storage facilities, land and much more.
Luckily, the first method people tend to have when thinking about real estate investing isn’t the only option available to you as a real estate investor. We will address these alternative investment options below.
When choosing to invest in real estate more passively (other than direct ownership), some of the benefits include:
- Diversifying your investment portfolio.
- The possibility of earning money both through dividends and eventual sales.
- Low starting costs (depending on your investing preference).
- Having a tangible asset that hedges against inflation.
- A variety of tax deductions.
Directly renting your properties without a third party and remodeling and “flipping” houses can be very profitable, but they are also active work.
Renting out a vacation home short-term is less work than owning an apartment building with tenants where you need to get money from each month, but even the first option can require a lot of effort.
You can pay a third-party management company to maintain the property for you to make this income source more passive (but you still need to work with them).
Fortunately, there are many ways to earn income from real estate that are truly “set it and forget it” methods. The investment strategies below can either make you money right away, sit as a long-term investment, or do both!
Taxes for Passive Real Estate Investing
Passive income from real estate investing comes with several tax advantages. One of the main benefits is deducting expenses against your taxable income.
Some of your deductions may include:
- Property maintenance, repairs, or improvements
- Property tax
- Landlord insurance
- Marketing expenses
- Mortgage interest
- Property management fees
If you choose to invest in real estate with an entity, such as a limited partnership (LP) or limited liability company (LLC), you open yourself up to even more deductions.
You may be able to deduct office space and supplies (including a home office), legal and professional fees, and certain travel expenses.
These can qualify as self-employment tax deductions. You may also deduct relevant membership fees and meals with current or prospective clients, though special rules apply.
Another common tax advantage for real estate investing is MACRS depreciation. When you own an income-producing investment property for at least a year, you can slowly depreciate the property’s cost. This means you can deduct a property’s loss in value over its expected life.
For residential properties, this is considered 27.5 years and commercial property is considered 39 years. Additionally, you can depreciate certain capital expenses, such as replacing a roof.
Note that when a property is sold, the IRS requires you to include recaptured depreciation on the Section 1231 or 1250 property. This requires the seller to realize the accumulated depreciation as ordinary income with a cap at 25%.
However, you can avoid a depreciation recapture with a Section 1031 exchange. This tax arrangement, colloquially referred to as simply a “1031 exchange” receives its name from Section 1031 of the IRS tax code.
It is a legal transaction where real estate investors swap an investment property for a like-kind property, thus avoiding capital gains and depreciation recapture on the property’s disposition (sale or transfer).
For real estate investing, when you sell a property you owned for a year or longer, you can pay advantageous long-term capital gains taxes rather than ordinary income taxes.
However, if you sell a property for more than you paid for it and owned it for less than a year, these gains fall subject to short-term capital gains, equivalent to ordinary income taxes.
Typically, capital gains are typically a lower tax rate than ordinary income, depending on your income level.
Overall, the taxes involved with real estate investing can become tricky. If you have little experience earning passive income from real estate investing, I highly recommend consulting a professional.
The cost of a tax professional can more than pay for itself when they find all the possible tax breaks for your situation.
Real estate investments tend to have more stable returns over time as compared to stocks. These predictable and tax-advantaged returns make real estate an excellent addition to your investment portfolio.
Further, over the long-run, these investments act as a great hedge against inflation. Some require more work than others, making some forms of real estate investing feel like a full-time job. Others listed, however, can create more passive income streams for your financial picture.
Thankfully, now, more than ever, you have numerous options for investing in real estate. Depending on your available capital, risk tolerance, willingness to invest your time and investing time horizon, the options laid out above would likely appeal to your long-term investing goals.
What Are REIT Investments?
REIT stands for Real Estate Investment Trusts. These trusts are companies that buy, manage, and oversee the legal issues of a property producing income.
This can be either rental income from residential properties or commercial income from office buildings etc. As an investor, you can buy a part of these properties and receive dividends from their income every month.
A real estate investment trust (REIT) is a company that owns income-producing real estate and pools investors’ money to gain and manage real estate properties. Typically, REITs are high-end or commercial properties and they can fluctuate in correlation with the stock market.
REITs allow you to invest in the real estate sector in a completely passive manner as you essentially own a share of the fund. The rental payments pass through to REIT owners on a monthly, quarterly, or annual basis.
People who invest in REITs receive dividends in the same way you receive dividends from certain stocks and these returns are usually higher than most other stocks.
A benefit to REITs that you don’t have with a lot of other real estate investments is that your money stays liquid because you can sell at any time.
The upfront costs for investing in a REIT are relatively low and they are simple to purchase through a brokerage account.
If you find choosing between hundreds of publicly-traded REITs intimidating, you might consider investing in a real estate exchange-traded fund (ETF).
With ETFs, a professional fund manager decides which REITs to invest in and uses investors’ money to buy groups of REITs. There are far fewer options to choose from if you want an ETF instead.
In a nutshell, REITs work like mutual funds for investors who cannot afford or manage real estate properties independently.
By investing in a REIT, you actually own a small part of their real estate properties. This means if you want to earn real estate income without any hassle, REIT passive income is the answer for you.
However, there’s a specific learning curve involved when it comes to REITs. Although it sounds as easy as ABC, you cannot just jump in without knowing the ropes.
That’s why I’ve compiled everything you need in this guide to REIT passive income so that you can decide whether it’s the ultimate option for you or not.
How Does a Company Qualify for REIT Passive Income?
Not every company that owns income-generating properties can qualify as a REIT. There are certain rules and guidelines involved, and if the company does not adhere to them, it won’t be allowed to deal with real estate investors.
As an investor, you should know these basic guidelines before choosing which company you should invest in for REIT passive income.
First of all, the company should be a legit corporation complying with the IRS revenue code. Besides that, it should be equipped with a good board of directors and have more than a hundred shareholders holding their stakes.
Moreover, a company would only be considered a REIT if it has at least 75 percent of its assets in the US treasury or real estate assets, while 75 percent of its net income should come from real estate investments.
Most importantly, because REITs don’t have to pay tax, about 90% of their taxable income should go to their shareholders and investors.
The company is deemed legit enough to allow investors to pool in their money if it complies with these conditions. That’s why you should conduct thorough real estate due diligence on the company you’re planning to invest in.
Is REIT Passive Income Profitable?
Without a doubt, REITs are one of the highest paying real estate investments. This is evident from the FTSE NAREIT Equity REIT Index according to which REITs provided about 9.9% annual returns to its investors between 1990 and 2010.
This is the highest investment return rate compared to fixed income assets that only paid 7% annual returns. Additionally, REITs performed even better in recent years, providing about 11.21% in annual returns to investors between 2013 and 2016.
This means investors with diverse investment portfolios who’re looking for high-yield investments should go for REIT passive income. Even if you can’t afford your own property, all you have to do is invest in a reliable REIT and receive a hassle-free payment.
While this might sound quite attractive initially, the income comes with taxation consequences, which you should know before diving in. Here’s a list of the types of REITs you can choose from, along with the taxation details for traditional REITs, to make things easier for you.
Types of REITs
Retail REITs
Retail REIT investment is easily the highest and most popular investment in the US. REIT companies own most of the shopping malls and arenas you see on an everyday basis are.
That’s why shopping malls and other retailers make up almost 24% of all REIT investments. However, before investing for REIT passive income with a company investing in retail, you should consider whether the retail market is thriving in the current financial environment.
Residential REITs
Everyone needs a space to live in, and that’s what fuels residential REITs to produce significant income for their investors.
Residential REITs own and operate different types of residential property, including apartment buildings and traditional housing. While investing in residential REITs, you should look for places that offer low affordability for homes.
Healthcare REITs
Healthcare REITs invest in the construction of hospitals, nursing homes, retirement homes, and medical centers.
With the US’s growing healthcare costs, the rental prices in this sector are likely to climb up, making it a profitable real estate investment. However, the profitability of these investments highly depends on whether the healthcare bill gets passed.
When investing with a healthcare REIT company, make sure that the company doesn’t rely entirely on the property and has other diversified options. If you choose to invest in a REIT that relies entirely on healthcare investments, check their history to see whether they have significant experience in the sector.
Commercial REITs
These REITs invest in office buildings and receive rental income from corporate tenants.
While investing in a commercial REIT, you should check the unemployment rate, economic growth rate, along overall vacancy rates to see whether your investment will bring significant profits.
A good idea is to look for commercial REITs in cities considered major job-providers in the country. These include New York, Washington DC, and Los Angeles.
Mortgage REITs
All of the types of REITs mentioned above were equity REITs. This means they buy and manage the properties themselves and share the rental income they make with their investors and shareholders.
On the other hand, Mortgage REITs is a whole different story. Making up about 10% of all REIT passive income, mortgage REITs give out money to people who want to buy real estate.
Besides that, they also work by buying mortgages and securities backed by existing mortgages as well. In plain terms, this means instead of funding a company to acquire a property, you’re actually paying a company that will lend your money to someone else who wants to buy real estate.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor, media buyer, faithful Red Sox Fan.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here, or get a hold of him on Facebook or Twitter.
