Real Estate Investment Trusts (REITs) are trusts, owned by shareholders who can exchange their shares on the open market. REITs provide a means by which relatively small investors can participate in large-scale real estate investments. REITs are very heavily invested directly in real estate.
REIT is a creature of the federal tax law. It was created in 1960 with the goal of encouraging small investors to pool their resources with others in order to raise venture capital for real estate transactions. It has been called the "mutual fund" of the real estate business. Just as mutual funds invest in a diversified portfolio of corporate stocks and bonds, REITs invest in a diversified portfolio of real estate and mortgage investments, with a large number of investors who combine or pool their funds.
REITs are conduits for investment income only. They are organized under state law as unincorporated associations managed by trustees. They are creatures of federal tax law which permits their distributions to shareholders to be nontaxable to the trust, so long as certain requirements are met. They provide a means by which relatively small investors can participate in large-scale real estate investments.
♦ Requirements - Briefly, at least 90% of ordinary income must be distributed to shareholders; more than 75% of assets must be real estate and more than 75% of income must come from such investments; there must be 100 or more shareholders with no fewer than six owning more than half the trust; the trust may not hold property for sale to customers in the ordinary course of business or provide services to tenants except through independent contractors.
♦ Tax treatment - REITs are tax-exempt only on the income passed through, and shareholders must pay personal income tax on that. Passthroughs of depreciation may offset ordinary income and passthroughs of capital gains do receive capital gains treatment. Under the Tax Reform Act of 1986, profits and losses are classified as "passive" income, putting limitations on the deductibility of ordinary losses.
During the economic crisis of the 1970s, many REITs folded under the pressures of poor management, excessive speculation, withdrawal and cancellation of take-out commitments, terminations of bank lines of credit, poor credit analysis, excess building in many parts of the country (particularly in the condominium market and in recreational projects), and sagging demand.
In the 1980s, to restore confidence in the REIT, concessions worked out between REITs and the banking and securities industry slowly revived REITs. This slow revival continued until the late 1990s, when a hot stock market put a damper on REITs. By 2001, the stock market declined and some money began to flow back into REITs.
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