What is the difference between an REIT and a master limited partnership?

Real estate investment trusts (REITs) and master limited partnerships (MLPs) are both considered pass-through entities under the U.S. federal tax code. Most corporate earnings are taxed twice, once when the earnings are booked and again when distributed as dividends. However, the pass-through status of REITs and MLPs allows them to avoid this double taxation since earnings are not taxed at the corporate level. While they receive similar tax treatments, the business characteristics of REITs and MLPs differ in several ways.

The most notable difference is that a REIT is widely considered a financial sector investment, while most MLPs are found in the energy and natural resource sectors. An REIT may act as a holding company for debt and earn interest income, as in the case of a mortgage REIT, or be actively involved in managing properties and generate revenues from rent (an equity REIT). With a few notable exceptions, the MLP structure is mostly used by companies that own and operate midstream energy assets. These are classic toll-road businesses that derive their earnings from the fees they charge for transporting oil and gas through their pipelines. (For related reading, see "5 Types of REITs and How to Invest in Them.")

The distribution requirements also differ for REITs and MLPs. In exchange for their special tax status, REITs must pay out 90% of earnings in the form of dividends to their shareholders. MLPs target a specific dividend rate, which management is incentivized to achieve, but they are not required to distribute a certain percentage.

Distributions are also treated differently on the receiving end. While REIT distributions come with a tax liability for the investor like any other dividend, MLP distributions are often tax-free. For this reason, MLPs are not ideal investments for individual retirement accounts (IRAs). (For related reading, see "Can I Own Master Limited Partnerships (MLPs) in My Roth IRA?")

REITs have deeper access to debt markets, so they typically operate with more leverage than MLPs. The ratings agency, Fitch, estimates REITs are leveraged five to six times over, while MLPs operate in the 3.5 to 4.5 range. In terms of their legal structures, most REITs have a publicly traded parent company, while MLPs are classified as partnerships. Investors in an MLP are referred as "unit holders" and do not participate in how the partnership is managed (this is the responsibility of the general partner, which may or may not be listed as a public equity).

Even with these differences, REITs and MLPs both operate with the same goal: to return more hard-earned capital to shareholders and remit less to the government via taxes. Still, due diligence is especially important when considering an investment in these yield vehicles. Distributions depend largely on cash flow rather than earnings, requiring a valuation discipline that goes beyond the price-to-earnings (P/E) ratio. Investors should also be comfortable with the occasional secondary offering, which can cause volatility in share prices.

(For related reading, see "If MLP Investing Is Dangerous, Are REITs Safe?")