Why Should Our Investment Club Avoid REITs?
Posted by: Doug Gerlach 10/1/2012 3:33:07 PM

In response to my BetterInvesting magazine article "Club Tax Returns: 10 Things You Gotta Know" in the February 2012 issue, a reader asks "I would like to ask if you might elaborate on the topic of 'workarounds and additional steps to properly report the tax liabilities' of these securities, with a particular focus upon REITs."

Lawrence S. continues, "The topic of REITS came up at our last club meeting as a category to investigate. I offered to look further into the topic and later remembered reading that 'some' investments proved to be tax reporting 'nightmares.' I ask you my question not to debate but rather to learn more information I might report back to my club."

The problem with holding Real Estate Investment Trusts (REITs) in a partnership has nothing to do with our club accounting software, Club Accounting 3 or myICLUB.com, but with how the dispensation of REIT income is reported to shareholders, which is not conducive to investing partnership accounting principles.

REIT distributions can contain up to four different classifications of funds: dividends (which are always non-qualifying), short-term capital gains, long-term capital gains, and/or returns of capital (and there’s sometimes one more figure reported, which I’ll discuss below).

Each of these categories are treated differently for tax purposes. But REITs only report the breakdown of distributions at year-end on their Form 1099s. That’s fine for individual investors, but for investing partnerships it’s a problem. That’s because partnerships account for the dispensation of each distribution separately when recorded on the club’s books, allocating the amount of the distribution as appropriate to each member relative to their ownership in the club at the time the distribution was received.

So, this means that the four quarterly distributions you’ve recorded in the club’s books for the year don’t represent the complete accurate picture. The quarterly distribution you receive is just a check or a deposit into your account, with no notice as to the breakdown of the money contained in it. To record the right information in the club’s books once the 1099 is received, the treasurer must now do something like this.

  1. Make sure in Security Settings that the REIT is set as type Stock > REIT. REITs are not common stocks, so you must tell the program that you’re dealing with a REIT so that it can handle the security appropriately. If you don’t do this, then the amount of qualifying vs. non-qualifying dividends will not be calculated properly in the books
  2. Record the four quarterly distributions in your books as a sort of placeholder transaction, usually as a “dividend.”
  3. Calculate the percentage of each category of distributions relative to the total reported on the 1099.
  4. Delete each quarterly distribution previously recorded on the club’s books.
  5. For each quarterly check received from the REIT, enter up to four new transactions, one for each of the four possible categories of distributions (short-term capital gains, long-term capital gains, dividends, return of capital), applying the percentage calculated in #1 to the quarterly payment to determine the appropriate amount.
  6. Make sure that the totals entered all add up to the amounts reported on the 1099. Some rounding is probably going to be needed when calculating the percentages, so double-check to make sure you’re not off by a few pennies here or there (which won’t affect your tax return, but will drive you or the next treasurer crazy when the books never balance).
  7. Your 1099 may also include an amount for “Unrecaptured Section 1250 distributions.” This is the amount of depreciation claimed on the real property or partnership sold which is not reported as ordinary income. Unrecaptured Section 1250 gains are taxed at a 25 percent capital gains tax rate. When you generate your year-end allocation of income and tax forms from myICLUB.com, you will be asked if this amount is non-zero, and you should fill it in at that point, and the Club Tax Printer will pick it up and report it appropriately to the partners.
  8. Heaven forbid if you have dividend reinvestment enabled for a REIT, since you have to account for the reinvestments, as well. I would not use the Reinvested Distribution transaction for these, but would record the four quarterly distributions as cash and then make a single Buy from the proceeds. The Reinvested Distribution transaction is just a shortcut that streamlines the entry of reinvestments instead of having to enter a distribution and then a purchase, so this won’t affect the cost basis, and will prevent the creation of 12 additional tax lots in the program (4 for each quarter) compared to entering 4 quarterly reinvestments.
  9. Finally, if after reviewing the above, if there are members of the club who are strongly advocating that the club should own REITs, make sure that they are put on notice that they are the leading candidate to become the next club treasurer!

The above generally apply to Master Limited Partnerships and other investing partnerships, but those have some even more onerous consequences for investment clubs.