So you’ve inherited some property and don’t particularly like the vision you’re having of your future self as a curmudgeonly landlord bent over a leaky toilet your tenants want fixed?
Start by asking yourself whether the property is worth hanging on to. Get an appraisal of the property, consider trends in the local real estate market, and potential income or perceived price appreciation of the property. If you’ve done all that, and you decide it’s not something you wish to get into, it might be time to sell.
But maybe you do like the idea of having a stream of rental income or otherwise being invested in real estate. No need to be torn. You could consider selling the property and using the proceeds to buy into the real estate investment trust (REIT) market.
Taking a Look at REITs
First things first…
There are two basic types of REITs—those that are traded on exchanges (“exchange-traded REITs”) and those that are not (“non-traded REITs”). While there may be opportunities in non-traded REITs, they’re not for everyone. They’re typically illiquid, meaning if you want to sell your investment, there may not be a readily-available buyer. Plus, many non-traded REITs are subject to upfront fees and minimum holding terms (aka “lockup periods”).
For the balance of this article, we’ll be looking at exchange-traded REITs.
And remember: some REITs can be quite complicated from a tax perspective. You may wish to consult your tax advisor before investing.
In comparing REITs to a rental property, although both types of real estate holdings can offer a potential source of steady rental income, exchange-traded REITs may offer better liquidity. Investors can generally purchase the common stock, preferred stock, or debt security of exchange-traded REITs. Investors can also purchase REIT shares through the purchase of exchange-traded funds (ETFs).
In addition to being more easily bought and sold than physical property, exchange-traded REITs can be used to help diversify a stock portfolio because real estate tends to have a low to moderate correlation with stocks. And speaking of diversification, selling a rental property in favor of a REITs-focused fund can allow you to spread your real estate holdings across the fund’s holdings—residential and commercial—and across geographies.
REITs are legally bound to pay out most (generally 90%) of their taxable income as dividends to shareholders each year. Perhaps best of all, you’re delegating all the leaky toilet issues to somebody else.
Unless people have a knack for the real estate market or maintenance work, they tend to divest properties they inherit, says Jeff Fosselman, senior wealth advisor for wealth manager Relative Value Partners, based in Northbrook, Illinois. Of course, hiring someone else to manage the property would eat into profits, he says.
He has seen some people switch these properties out for REIT investments.
“They just don’t have the hands-on comfort level for managing property,” he said.
Growth in Real Estate Investing
Since 1990, the equity market capitalization of the U.S.-listed equity REIT industry has surged from $9 billion to nearly $1 trillion, according to the National Association of Real Estate Investment Trusts (NAREIT). And in September 2016, S&P Dow Jones Indices, added real estate as the 11th sector of its benchmark S&P 500 Index.
Some investors say this growth speaks to the recognition of real estate as an asset class worth considering as part of a diversified portfolio.
Potential Tax Issues
Happily, income tax implications for selling a property soon after you inherit it tend not to be a big deal, Fosselman said. That’s because property tends to be sold relatively quickly after someone’s death, keeping the time short for any gains after it is reassessed, he said. But, commissions for real estate agents and costs for putting up a property for sale eat into any gains, he added.
However, property taxes can drastically increase after a property is reassessed following a death, he said. That just makes for another reason to sell, he said.
Of course, there are also tax considerations with owning exchange-traded REITs.
The majority of dividends you’ll earn from REITs will be taxed as ordinary income, Fosselman said. And selling your REIT holdings can generate capital gains tax, he added.
Be sure to consider your own financial situation, perform thorough research and consult with a qualified tax professional before making any investment decisions concerning REITs. Investments in REITs and other real estate securities are subject to the same risks as direct investments in real estate. The real estate industry is particularly sensitive to economic downturns.
You may also want to review this SEC Investor Bulletin concerning REIT investing.