Seven: Distributions taxed as ordinary income
REITs can be tricky at tax time. By law, REITs must pass 90% of their income through to shareholders, who are liable for taxes on that income without the benefit of a favorable capital-gains tax rate. The distributions are taxed as ordinary income, in other words. That’s not great news for investors in high tax brackets.
However, there’s a good side to this arrangement. REITs’ income is taxed only once, at the shareholder level. This is unlike corporate dividends, which are taxed once at the corporate level and then taxed again to shareholders. Hence the term double taxation.
Because of this, REITs are best suited for tax-deferred entities such as IRAs and 401(k) accounts.
Eight: You can buy individual REITs
You can buy individual REITs, just as you can buy individual stocks and bonds. But by far the best way to own REITs is through a mutual fund. Vanguard’s low-cost REIT Index fund VGSIX, -0.17% is hard to beat. It is broadly diversified, holding 142 REITs compared with only 57 for Cohen & Steers Realty Shares CSRSX, -0.16% a popular actively-managed REITs fund.
Over the past 15 years, the Vanguard fund’s performance was almost one full percentage point higher than the average REIT fund.
Nine: You can buy international REITs
Now it’s possible to invest in international REIT funds; some are global; others own only properties outside the U.S. These multinational funds don’t have long return histories, but the experts who follow them believe that combining U.S. and international real-estate investments will produce higher returns than the S&P 500 index, along with currency diversification.