REIT vs Mutual Fund: Key Differences in Structure, Tax, and Liquidity

Investors seeking diversified exposure to financial markets often consider Real Estate Investment Trusts (REITs) and mutual funds. While both pool money from multiple investors, they differ significantly in structure, taxation, liquidity, and costs. Understanding these differences helps investors make informed decisions.

Legal and Regulatory Structure

REITs and mutual funds operate under distinct legal frameworks that shape their governance and compliance obligations. REITs are governed by the U.S. Internal Revenue Code under sections 856-860, which impose strict requirements on income sources, asset composition, and distribution mandates. At least 75% of a REIT’s total assets must be in real estate, cash, or U.S. Treasuries, and at least 75% of its gross income must come from real estate-related sources such as rents or mortgage interest. Additionally, REITs must distribute at least 90% of their taxable income to shareholders annually to maintain their tax-advantaged status. Failure to meet these criteria results in the loss of REIT designation and corporate taxation.

Mutual funds, regulated under the Investment Company Act of 1940 and overseen by the Securities and Exchange Commission (SEC), must comply with disclosure, reporting, and fiduciary requirements. Unlike REITs, mutual funds have no asset composition restrictions, allowing them to invest in equities, bonds, and derivatives. They qualify for pass-through taxation under Subchapter M of the Internal Revenue Code if they distribute at least 90% of their income to shareholders. Mutual funds must also follow diversification rules, such as the 50% diversification test, which limits holdings in any single issuer to 5% of total assets and restricts ownership to 10% of a company’s voting securities.

Governance and investor protections differ as well. REITs can be publicly traded, private, or non-traded, each with varying levels of SEC oversight. Publicly traded REITs must file periodic reports, while private and non-traded REITs have fewer disclosure requirements, increasing risks related to transparency and liquidity. Mutual funds must meet stricter governance rules, including board composition requirements mandating at least 40% independent directors. They also adhere to daily net asset value (NAV) calculations and redemption policies, ensuring investors can buy or sell shares at fair market value.

Asset Composition

The assets within REITs and mutual funds define their risk profiles and return potential. REITs primarily hold income-generating real estate, including commercial properties, residential complexes, industrial facilities, and specialized sectors like data centers and healthcare facilities. Their valuation depends on property market cycles, rental income stability, and capitalization rates. Equity REITs, which own physical properties, generate returns from rental income and property appreciation, while mortgage REITs (mREITs) invest in real estate debt instruments, profiting from interest rate spreads. mREITs are highly sensitive to Federal Reserve policy changes, as interest rate fluctuations impact borrowing costs and net interest margins.

Mutual funds offer exposure to a broader range of financial instruments, including equities, fixed-income securities, commodities, and alternative investments. Equity mutual funds focus on publicly traded stocks, valued based on earnings growth, market sentiment, and macroeconomic factors. Bond funds invest in government, municipal, or corporate debt, with returns influenced by credit quality, duration, and yield curves. Some mutual funds use derivatives like options and futures to hedge risk or enhance returns, a strategy not commonly employed by REITs due to their real estate focus. Sector-specific mutual funds may concentrate on industries like technology or healthcare, while balanced funds allocate assets between stocks and bonds for a mix of growth and income.

Liquidity constraints and valuation methods further distinguish these investments. Publicly traded REITs trade on exchanges, allowing for real-time price discovery, while non-traded REITs update NAVs periodically, making valuation less transparent. Mutual funds calculate NAV at the close of each trading day based on the market value of their holdings, ensuring a clear pricing mechanism for investors.

Distribution Mechanics

REITs and mutual funds distribute profits differently, affecting income predictability and tax efficiency. REITs primarily return earnings through dividends funded by rental income, lease payments, or mortgage interest. These payments are typically made quarterly, though some REITs offer monthly distributions to attract income-focused investors. The amount distributed depends on funds from operations (FFO), which adjusts net income by adding back non-cash depreciation and amortization expenses. Since real estate assets depreciate on financial statements despite often appreciating in value, FFO provides a clearer picture of a REIT’s ability to sustain distributions. A payout ratio above 100% may indicate that distributions exceed cash flow, potentially requiring capital raises or asset sales.

Mutual funds distribute income based on interest, dividends, or capital gains from their portfolio holdings. Bond funds typically issue monthly distributions reflecting coupon payments, while equity funds pay dividends based on stock holdings, often quarterly or annually. Capital gains distributions occur when fund managers sell appreciated securities, triggering taxable events for shareholders. Unlike REITs, which emphasize steady income, mutual fund distributions fluctuate based on portfolio turnover and market conditions. Actively managed funds with high trading activity may realize frequent gains, leading to irregular distribution patterns. Index funds, which passively track benchmarks, tend to have lower turnover and more predictable payouts.

Reinvestment options also differ. Many mutual funds offer automatic dividend reinvestment plans (DRIPs), allowing investors to use distributions to buy additional shares without brokerage fees. This compounding effect enhances long-term returns, particularly in growth-oriented funds. While some publicly traded REITs provide DRIPs, participation rates are lower since many investors prioritize cash flow. Non-traded REITs often reinvest distributions by default during early years but may transition to cash payouts as properties mature and generate stable rental income.

Tax Treatment

Taxation impacts investor returns, with differences in how distributions are classified and taxed. REIT dividends fall into three categories: ordinary income, capital gains, and return of capital. Ordinary income distributions, derived from rental earnings and interest, are taxed at the investor’s marginal tax rate, which can be as high as 37% for top earners in 2024. Qualified dividends, which receive lower tax rates of 0%, 15%, or 20%, are rare for REITs since most earnings do not meet IRS requirements for preferential treatment. Capital gains distributions, from property sales or asset appreciation, are taxed at long-term capital gains rates if the REIT held the property for over a year. The return of capital portion reduces an investor’s cost basis, deferring taxes until shares are sold.

Mutual fund taxation depends on the type of earnings distributed. Interest income from bond funds is taxed as ordinary income, while dividends from equity funds may be classified as qualified or non-qualified depending on the underlying securities. Capital gains distributions occur when fund managers sell appreciated assets, passing tax liabilities to shareholders even if they did not sell their own shares. High-turnover funds, such as actively managed portfolios, can generate significant taxable events, making tax-efficient funds, such as index funds or ETFs, more attractive for investors in higher tax brackets.

Liquidity

Liquidity varies between REITs and mutual funds, affecting investor flexibility. Publicly traded REITs offer high liquidity, as their shares trade on major stock exchanges like the NYSE and Nasdaq, allowing investors to enter or exit positions throughout the trading day at market prices. However, non-traded REITs lack this advantage, as they do not list on exchanges and often impose holding periods or redemption restrictions. Investors in non-traded REITs may need to wait for liquidity events, such as asset sales or public offerings, to access their capital.

Mutual funds, particularly open-end funds, provide liquidity through daily redemptions at NAV. Investors can buy or sell shares at the fund’s NAV, calculated at the close of each trading day. This structure ensures price transparency but prevents intraday trading, unlike exchange-traded REITs. Closed-end funds, a subset of mutual funds, trade on exchanges like stocks, meaning their prices fluctuate throughout the day based on supply and demand rather than NAV. Some mutual funds impose redemption fees or short-term trading penalties to discourage frequent trading, which can impact liquidity for investors seeking immediate access to funds.

Cost Structure

Expenses affect net returns, with differences in management fees, transaction costs, and operational expenses. REITs incur costs related to property management, leasing, and maintenance, reflected in their expense ratios. Publicly traded REITs typically have expense ratios ranging from 0.50% to 1.50%, while non-traded REITs often carry higher fees due to upfront sales charges and marketing costs. Some non-traded REITs impose fees as high as 10% to 15%, significantly reducing initial investment value.

Mutual funds charge expense ratios that vary based on management style and asset class. Actively managed funds generally have higher costs, with expense ratios averaging between 0.50% and 1.50%. Index funds and ETFs, which passively track benchmarks, offer lower expense ratios, often below 0.10%. Some mutual funds impose front-end or back-end load fees, which either reduce the initial investment amount or apply charges upon redemption. High fees can erode returns over time, particularly in actively managed funds with frequent portfolio turnover.