Real estate investment trusts make money in three ways: they collect rent from properties they own, they earn interest on mortgage loans and mortgage-backed securities they hold, and they book capital gains when they sell properties for more than they paid. Federal tax law then forces most of that income back out the door, because a REIT has to distribute at least 90 percent of its taxable income to shareholders each year to keep its tax-advantaged status.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries That is why REIT dividends run so much higher than ordinary stock dividends, and it is the mechanism by which the money a REIT earns reaches you.2SEC.gov. Investor Bulletin: Real Estate Investment Trusts (REITs)
Rent from Properties the REIT Owns
Equity REITs own physical real estate and collect rent from tenants. This is the largest revenue source across the industry, and the mechanic is the same regardless of property type: a retail REIT collects from stores in its shopping centers, a healthcare REIT from hospitals and medical offices, an industrial REIT from warehouse operators. Tenants pay for the right to use the space, and those payments flow through to shareholders as dividends.
The tax code narrows what counts. At least 75 percent of a REIT’s gross income has to come from real-estate-related sources, and rent from real property is the largest qualifying category.3Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust Payments for the use of space and for customary services like lobby maintenance qualify. Rent that depends on a tenant’s net income or profits does not, because the IRS treats that as profit-sharing rather than a passive real estate return.
There is one important carve-out. Rent calculated as a fixed percentage of a tenant’s gross sales still qualifies. Retail leases use this constantly: a mall REIT might charge a flat monthly rent plus 6 percent of any gross sales above a set breakpoint. The REIT gets upside when tenants do well without crossing into the profit-sharing that would jeopardize its status.
Lease Structures That Stabilize the Cash Flow
Many commercial and industrial REITs use triple net leases, where the tenant pays rent plus property taxes, building insurance, and maintenance. The REIT receives a cleaner stream of income because fluctuating operating expenses sit with the tenant. Terms often run ten to twenty years in commercial settings. Well-run portfolios keep occupancy in the 90 to 98 percent range, so the revenue base stays steady even as individual tenants turn over.
How Different Sectors Earn Rent
Rental income does not look the same everywhere. A cell tower REIT leasing rooftop or ground space to wireless carriers typically locks in five-year initial terms with automatic renewals and annual rent escalators. A data center REIT charges premium rates per square foot because tenants need specialized power and cooling. A self-storage REIT relies on volume and month-to-month leases, which lets it raise rates quickly but offers less long-term certainty per tenant. Every dollar of qualifying rent counts toward that 75 percent income threshold.
Interest from Mortgage Loans and Securities
Mortgage REITs work differently. Instead of owning buildings, they invest in real estate debt and earn interest. A mortgage REIT might originate loans directly, buy existing mortgages from banks, or hold mortgage-backed securities. The profit is the spread between what those assets pay in interest and what the REIT pays to borrow the money used to buy them. That spread is called the net interest margin, and it is the central performance metric for the sector.
Interest on mortgage obligations secured by real property qualifies under the same 75 percent income test that governs rent, so mortgage REITs satisfy the statutory threshold through debt investments rather than property ownership.3Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust Their cost structure looks nothing like an equity REIT’s. Expenses center on credit analysis, portfolio management, and hedging, not roof repairs.
Agency Versus Non-Agency Debt
The risk profile depends on what kind of debt the REIT holds. Agency mortgage-backed securities carry an implicit or explicit federal guarantee through Fannie Mae, Freddie Mac, or Ginnie Mae, which effectively eliminates credit risk.4Federal Reserve Bank of Richmond. Assessing the Risks of Mortgage REITs Yields are lower as a result. Non-agency securities lack that backing, so credit risk is higher and so are potential returns. A REIT concentrated in agency paper is making a leveraged bet on interest rates; one in non-agency debt is also betting on borrower creditworthiness.
What Happens When Rates Move
Rate changes work both ends of the margin. When rates drop, homeowners refinance and mortgage REITs get principal back early, forcing reinvestment at lower prevailing yields. When rates rise, borrowers hold onto their low-rate mortgages longer while the REIT’s own funding costs climb. Mortgage REITs routinely use interest rate swaps, caps, floors, and other derivatives to manage this exposure. Hedging costs eat into profits but keep revenue from swinging violently across rate cycles.
Capital Gains from Selling Property
Equity REITs are not passive holders. Active portfolio management means buying properties, improving them, and eventually selling the ones that have reached their peak value or no longer fit the strategy. The profit on those sales is a capital gain and can be a meaningful share of total returns in any given year. A REIT might buy an underperforming office park, renovate it, stabilize occupancy, and sell it five years later at a substantial markup, then recycle the proceeds into new acquisitions.
One point of confusion worth flagging: these gains are not part of Funds From Operations, the industry’s standard performance metric. FFO specifically excludes gains and losses from property sales along with real estate depreciation and amortization. Property sales are lumpy, so including them would distort the picture of recurring cash generation. Investors look at FFO for the ongoing income story and track capital gains separately.
The 100 Percent Prohibited Transaction Tax
Selling too much or too quickly is dangerous. If the IRS decides a REIT sold property as a dealer rather than as an investor, the entire gain from the sale is taxed at 100 percent. Not a penalty on top of regular tax. The whole profit goes to the IRS.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries Investors hold for appreciation and income; dealers buy and sell as a business. Property flipping is the archetype of what the rule targets.
Most REITs stay inside a statutory safe harbor to avoid triggering the tax. The trust must have held the property for at least two years, and capital improvements during that period cannot exceed 30 percent of the net selling price. There are also volume limits, with several ways to comply: no more than seven property sales in a year, or total adjusted basis of sold properties below 10 percent of total assets, or fair market value of sold properties below 10 percent of total asset value.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries Marketing or development work must be handled through independent contractors. Together, these conditions push REITs to treat sales as long-term portfolio moves, not trading.
Service Income and Taxable Subsidiaries
Some REITs earn additional money by providing property management, leasing services, or tenant amenities. A large apartment REIT might manage buildings owned by third parties for a fee. The problem is that management fees do not count as qualifying real estate income. At least 95 percent of a REIT’s gross income has to come from qualifying sources such as rent, interest, dividends, and gains from securities, leaving only 5 percent for anything else.3Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
To offer services tenants want without contaminating rental income, REITs use taxable REIT subsidiaries. A TRS is a separate corporate entity, fully owned by the REIT, that can provide non-customary services like concierge operations, fitness centers, or specialized maintenance. The subsidiary pays regular corporate income tax on its profits, but the parent REIT’s tax-advantaged status is unaffected. No more than 25 percent of a REIT’s total asset value can sit in these subsidiaries, which keeps the structure secondary to the core real estate business.3Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
Why the Money Reaches Shareholders as Dividends
The reason a REIT’s revenue matters to investors is that most of it is legally required to come back out. A REIT must distribute at least 90 percent of its taxable income to shareholders each year. If it falls short, the entire entity loses REIT status and gets taxed as a regular corporation, which roughly doubles the tax burden on its earnings.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries This is the reason REIT yields run so much higher than typical stocks. The trust cannot retain most of its earnings the way a normal corporation can.
Meeting 90 percent is not quite the end of it. A separate excise tax applies if a REIT distributes less than 85 percent of its ordinary income and 95 percent of its capital gain income during the calendar year. The penalty is 4 percent of the shortfall, due by March 15 of the following year.5Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts In practice, most REITs distribute well above the 90 percent minimum. A REIT can also elect to count certain dividends paid shortly after year-end toward the prior year’s requirement, provided the declaration happens before the tax return deadline and the distribution comes from that year’s earnings and profits.6eCFR. 26 CFR 1.858-1 – Dividends Paid by a Real Estate Investment Trust After Close of Taxable Year
The distribution rule also shapes how REITs grow. Because they cannot stockpile cash, REITs that want to acquire new properties or fund development typically issue new shares, take on debt, or sell existing assets. Their cost of capital and access to credit are constant concerns.
How REIT Dividends Are Taxed When You Receive Them
REIT dividends do not get the favorable tax rates that qualified dividends from ordinary corporations receive. Most REIT distributions are taxed as ordinary income at your marginal rate, which can reach 37 percent at the federal level. The logic is that the REIT itself pays little or no corporate tax thanks to the dividends-paid deduction, so the income is taxed only once, at the individual level, but at the full ordinary rate.
Section 199A of the tax code softens this. Individual shareholders can deduct 20 percent of qualified REIT dividends from taxable income, which effectively caps the top federal rate on those dividends at roughly 29.6 percent. The deduction, originally scheduled to expire after 2025, was made permanent. It applies regardless of income level and does not require itemizing or meeting the business-income limitations that apply to other Section 199A income.
Not every distribution is ordinary income. When a REIT designates part of a distribution as a capital gain dividend, reflecting profits from property sales, you pay the long-term capital gains rate, which tops out at 20 percent plus the 3.8 percent net investment income surtax.7Nareit. Taxes and REIT Investment And when distributions exceed the REIT’s earnings and profits for the year, the excess is treated as a return of capital. Return-of-capital distributions are not immediately taxable. They reduce your cost basis in the shares, which increases the eventual capital gain when you sell. Investors who do not track adjusted basis carefully can be surprised at tax time.