For example, if you receive a 7 percent distribution, you may pick up only about 5 or 6 percent in taxable income. The untaxed 1 or 2 percent is a return of capital distribution and is deducted from your cost basis, potentially raising the tax you owe when you sell.

But the effect is to defer income and shift highly taxed ordinary income to lower-taxed capital gains. Also, when a REIT sells a property for a capital gain, the gain is distributed to you and taxed at favorable rates (like an equity mutual fund.) REIT dividends that are not capital gain payouts generally do not qualify for the 15 percent tax rate under current law.(Based on recent history, about 75 percent of taxable REIT payouts are taxed at your regular rate, which can be as high as 35 percent.)

The Housing and Tax Assistance Act of 2008 made several technical changes in the tax rules for REITs. Check with your tax pro for more information.

REIT prices may fluctuate from year to year. Over the long-term, returns to investors reflect the values of the properties owned by each REIT. There is a wide variety to choose from, since some REITs specialize in one type of real estate or one region of the country while others buy properties nationwide. When investing, make sure the REIT properties are managed by experienced professionals.

Consider holding a small percentage of your portfolio in REITs or REIT mutual funds to help diversify your holdings so you don't rely too heavily on the stock market.