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December 1993

Wink Tax Services

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IN THIS ISSUE . . .

WHAT ARE REITís?

The extent of most peopleís investment in real estate begins and ends with their home. Not having the resources to purchase office buildings, large apartment buildings, or shopping centers, most people never invest in the commercial real estate market. However, real estate investment trusts (REITís rhymes with streets) are a vehicle for small investors to participate in commercial real estate.

REITís pool the funds of many people in a portfolio of real estate investments, similar to a mutual fund. REIT shares are publicly traded on the major stock exchanges and, like stocks, can have fluctuating principal and returns based on changing market conditions. There are four basic types of REITís:

EQUITY REITís own income-producing property such as apartment buildings, shopping centers, office buildings, etc. Shareholders earn income from rents and may receive capital gains when properties are sold.

Mortgage REITís own long-term mortgages and construction loans on commercial properties.

Hybrid REITís own income-producing property and mortgages.

Finite-Life REITís (FREITís) provide for termination of the trust at the end of a specified time.

REITís hold a special tax position ó as long as they meet several requirements, they do not have to pay corporate income taxes on their earnings. The major conditions are:

At least 95% of earnings must be distributed to shareholders;

At least 75% of revenues must be derived from rents, mortgage interest, and gains from property sales;

At least 75% of the assets must be invested in real estate, loans secured by real property, mortgages, shares in other REITís, government securities, and/or cash;

At least 100 shareholders must own shares, with no more than half the outstanding shares owned by 5 or fewer individuals;

Independent real estate professionals must perform certain management activities; and

Speculative, short-term holding of real estate is not permitted.

Dividends are considered portfolio income and cannot be used to offset passive losses from limited partnerships. If the distribution exceeds income and profits, it is considered a return of capital. Although tax-free to the shareholder, the basis is reduced. Net losses cannot be passed through to shareholders; they must be carried forward to offset future income. Gains or losses when the REITís are sold are treated as capital gains or losses for tax purposes.

THE ADVANTAGES OF REITís

Liquidity ó Since shares are traded on major exchanges, REITís turn a very illiquid asset into a liquid one. However, when you sell your shares, keep in mind that you will receive the current market value, which may be more or less than your original cost.

Professional Management ó Professionals are hired to provide management services, relieving shareholders of all management headaches.

Small Minimum Purchases ó Many REITís sell for less than $50 a share.

Diversification ó Many REITís own more than one investment property. It is possible to find REITís concentrating on certain types of property as well as certain geographic regions.

Dividend Reinvestment ó Most REITís allow shareholders to automatically reinvest dividends.

Record keeping ó The REIT keeps detailed records of transactions, providing you with all the necessary information for your tax return.

WHICH REIT IS BEST?

Numerous REITís are available, with a wide variety of investment objectives. The most fundamental decision is whether you should consider REITís, which will depend on your unique investment objectives. If you decide you are interested in REITís, you should consider several factors as REITís are subject to certain risk factors in addition to those inherent in any real estate investment:

  • Determine the type of REIT in which you are interested.
  • Examine the types of properties in the REITís portfolio, paying attention to diversification among property types and geographic location. Review the vacancy rates at the properties. Find out how much leverage is used in the REIT.
  • Check the tax status of the REIT, since there may be risks related to the interpretation and application of various tax rules associated with investment in REITís.
  • Review the history of dividend payments and the percentage of cash flow the dividend represents, keeping in mind that past performance is no guarantee of future performance.
  • Examine the relationship between the market price and book value of the REIT.
  • The management team is crucial, so carefully review their qualifications and experience. Examine the fees charged by management. Find out if management is investing their money in the project.

Give us a call at (800) 878-4036 to further discuss REITís in relation to your investment objectives.

TAXES AND MUTUAL FUNDS

It is important with all investments to understand the tax consequences of your investment activities. A basic review of the tax laws relating to mutual funds may help with your tax return.

MUTUAL FUND DISTRIBUTIONS

In order to maintain its tax status, a mutual fund must distribute income to shareholders before year-end. These distributions are taxable, even if you reinvest the distribution. Dividends declared late in 1993 but not paid until January 1994 are still taxable income for 1993.

The types of distributions you may receive include ordinary dividends, capital gains, exempt-interest dividends, and return of capital (nontaxable) distributions. Form 1099-DIV (Statement for Recipients of Dividends and Distributions) will disclose the amount of each type of distribution.

Interest from money-market and taxable bond funds is considered dividend income for tax purposes, even though the source of the income is interest. Capital gains distributions are considered long-term capital gains, regardless of the length of time you have held the investment.

If your mutual invests in foreign securities, your fund may have withheld foreign taxes, entitling you to a foreign tax credit. In order to get the credit, you must file IRS form 1116.

MUTUAL FUND SALES

In order to achieve the best tax result when you sell, you must keep detailed records of the basis of the shares you purchase. This can be a complicated task. Initially, your basis in the shares is the amount you pay, including sales commissions. Additional shares purchased will generally have a different price per share. Occasionally, funds may declare capital gains but retain the profits and pay taxes, increasing your basis. Funds also occasionally return a portion of your investment as a non-taxable distribution, reducing your basis. If you reinvest your distributions, you will be purchasing additional shares at varying prices.

For income tax purposes, the basis of mutual fund shares sold can be determined using the "first-in, first-out" (FIFO) method, the identifiable cost method, or an averaging method. Generally, the identifiable cost method will give you the best tax result, since you have the most control over the amount of gain or loss realized. With this method, you can sell the shares with the highest basis, thus lowering your capital gain. Or, if you need a large capital gain to offset other capital losses, you can sell those with the lowest basis.

In order to use this method, you must instruct the fund to sell shares that were acquired on a specific date for a specific price.

A major advantage of mutual funds is the ability to transfer funds within a family of mutual funds. Be aware that this is a taxable transaction, however, and that you are selling shares in the fund you are leaving, usually resulting in a gain or loss. You are also selling shares when you use check-writing privileges of mutual funds.

IS AN ARM FOR YOU?

The interest rate on an adjustable rate mortgage (ARM) changes at regular intervals in response to a designated interest index, meaning that your monthly payment will fluctuate over the term of the loan. Because lenders are not locked into a fixed interest rate, they try to make them attractive by offering low initial rates.

ARMs are often the best alternative for individuals with rising incomes, for those planning to move in 3 to 5 years, and for those who want the short-term cash flow benefits of lower interest rates.

Before deciding, you should get answers to the following questions:

What happens to the interest rate in the second year of the loan? Often, lenders will offer an ARM with a discounted first-year interest rate. Simply comparing first-year rates offered by various lenders will not tell you which will be the most effective in the long run.

How is the rate calculated? The interest rate on an ARM is linked to a designated interest index, usually one-year Treasury securities. Your lender then adds a margin to this rate, typically one to three percentage points, to come up with the rate you are charged. Whenever your rate is adjusted, verify the rate adjustment.

When does the interest rate change? ARMs usually are adjusted annually.

What are the caps? Common caps prohibit interest rates from rising more than 2% per year and 5-6% over the life of the loan.

What is the highest payment you may be required to make? Ask the lender to calculate the largest payment the loan might require and make sure you are comfortable with this amount.

What has happened to the lenderís rates in the past? Ask your lender to show you how your mortgage payment would have changed over the past ten years. This will give you some indication of the fluctuations you can expect in your mortgage payment.

Can you convert to a fixed-rate mortgage? Some ARMs allow you to convert to a fixed-rate mortgage after a certain number of months or years, without paying closing costs.

There is no easy way to decide whether an ARM is a good alternative. But it is well worth the extra effort to find the best financing.

TRADING ON THE EXCHANGES

After a stock is initially issued, its shares are traded in the secondary market on stock exchanges. Stock exchanges do not sell stocks, they simply provide a place where securities can be bought and sold. Only securities specifically listed on an exchange can be traded on that exchange.

The New York Stock Exchange (NYSE) is the largest and most prestigious exchange in the U.S., with over 1,700 securities listed. In order to trade on the NYSE, a company must meet certain criteria, including annual earnings of at least $2,500,000 for the most recent year and $2,000,000 for each of the two preceding years, net tangible assets of $18,000,000, common stock market value of at least $18,000,000, at least 1,100,000 publicly held shares, and at least 2,000 shareholders of 100 or more shares.

Also called the Big Board, the NYSE is a corporation with more than 1,200 members, each with a seat (or membership) on the exchange giving the holder the right to trade on the floor of the exchange. Brokers with a seat on the exchange are assigned to oversee and regulate the buying and selling of the stocks of several companies. The broker is a specialist for that stock; all other brokers who want to buy or sell that stock must see the specialist, participating in a two-way auction market.

The American Stock Exchange (AMEX) has over 800 companies listed, operating in a manner similar to the NYSE. Listing requirements are less stringent than those for the NYSE, thus attracting smaller firms.

Regional exchanges include the Midwest Stock Exchange in Chicago (center for futures trading), the Pacific Stock Exchange in Los Angeles and San Francisco, the Philadelphia Stock Exchange, the Cincinnati Stock Exchange, the Boston Stock Exchange, the Spokane Stock Exchange, the Honolulu Stock Exchange, and the Intermountain Stock Exchange in Salt Lake City. These exchanges were originally organized to trade local interest stocks, but now also trade some stocks listed on the NYSE and AMEX.

While approximately 3,000 stocks are traded on all of these exchanges, approximately 4,500 stocks are listed on the computer-based Nasdaq Stock Market. The Nasdaq Stock Market is now the second largest stock market in the world.

Another 20,000 stocks are traded in the OVER-THE-COUNTER (OTC) MARKET, which is regulated by the National Association of Securities Dealers (NASD). Unlike stock exchanges, there is no central location for the OTC market and it is not an auction market. Instead, one or more dealers becomes a market maker in a stock, agreeing to purchase shares at prices they determine. 11,000 stocks are listed on pink sheets, published daily by the National Daily Quotation Services.

NEWS AND ANNOUNCEMENTS

YOUR INVESTMENT PLAN

Donít approach investing in a haphazard manner. Take the time to develop an investment philosophy by following these steps:

1. IDENTIFY YOUR INVESTMENT GOALS.

Your goals will change over time, so you should reevaluate them periodically. It is important to consider a host of factors, including your need for liquidity, your desired rate of growth, your current income needs, your tax situation, and how long you are willing to hold your investments.

2. ANALYZE YOUR CURRENT INVESTMENT PORTFOLIO.

Calculate how much of your current investment portfolio is invested in each investment category. Be sure to include all of your investments, including employee pension funds, IRAs, and Keoghs.

3. DETERMINE AN APPROPRIATE ASSET ALLOCATION MIX.

Decide how much of your portfolio should be allocated to various investment categories. Not only will each individualís asset allocation strategy vary, but your strategy will vary over time.

4. DEVELOP A PLAN TO ADJUST YOUR INVESTMENTS TO YOUR DESIRED ASSET ALLOCATION MIX.

If you must make significant changes to your investment portfolio, you will probably want to do so over a period of time.

5. MONITOR YOUR PORTFOLIO PERIODICALLY.

It is important to review your portfolio at least annually. If you sell a stock due to poor performance, this can change the composition of your portfolio, making adjustments necessary. If one of your investments is very successful, you may find that it represents a larger percentage of your total portfolio than you desire.

An investment philosophy will give you a means to pursue your long-term goals in a manner you are comfortable with. If youíd like help with this process, please give us a call at (800) 878-4036.

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Disclaimer
We do not offer legal advice. All information provided on this website is for informational purposes only and is not a substitute for proper legal advice. If you have legal questions, we recommend that you seek the advice of legal professionals.

Tax Disclaimer: To ensure compliance with IRS Rules, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

Copyright © 2017 Wink Tax Services / Wink Inc.
Last modified: January 30, 2017