How the REIT Tax Exemption Works: Qualifying Tests and Shareholder Tax

The REIT tax exemption is really a deduction: a real estate investment trust that pays out at least 90% of its taxable income to shareholders can subtract those dividends from its own taxable income, which usually drops its federal corporate tax bill to zero. The entity looks tax-free, but the mechanism is a dividends paid deduction under Internal Revenue Code Section 857, and it only works if the REIT meets a demanding set of organizational, ownership, asset, income, and distribution rules.¹ Miss one of them and the REIT is taxed like any other corporation.

It’s a Deduction, Not an Exemption

A REIT is not tax-exempt the way a charity is. It’s a corporation, trust, or association that gets to deduct the dividends it pays shareholders from its taxable income. Send out substantially all of the income and the deduction cancels out substantially all of the tax.

That structure sidesteps the double taxation built into ordinary C corporations, where profits are taxed once at the corporate level and again when shareholders receive dividends. A qualifying REIT pushes its income out to shareholders largely untaxed at the entity level, and shareholders then pay tax on the dividends at their individual rates. The income is taxed once, not twice.

Qualifying as a REIT

Qualification is not a single test. It’s a running set of them, applied every quarter and every year the entity claims REIT status.

Structure and Ownership

Under IRC Section 856(a), the entity must be a corporation, trust, or association that would otherwise be taxed as a domestic corporation, managed by one or more trustees or directors, with ownership represented by transferable shares or certificates.²

Ownership then has to be genuinely spread out. Two rules do the work:

The 100-shareholder rule: at least 100 beneficial owners for at least 335 days of a 12-month taxable year, or the proportionate share of a shorter year.²
The 5/50 rule: during the last half of the taxable year, five or fewer individuals cannot own more than 50% of the value of the outstanding shares. The test uses the personal holding company mechanics in Section 542(a)(2), so indirect and constructive ownership counts.²

Publicly traded REITs usually clear both hurdles by default. Private REITs typically use charter restrictions and annual demand letters to confirm who really owns the shares before a concentration problem appears on the tax return.

Asset Tests

At the close of each fiscal quarter, at least 75% of the value of the REIT’s assets must be real estate assets, cash, and government securities.² Real estate assets include physical property, mortgage-backed interests, and shares in other REITs.

The other 25% has its own guardrails. Securities that don’t count toward the 75% test cannot exceed 25% of total assets. Securities of taxable REIT subsidiaries can’t exceed 20% of total assets. And, generally, a REIT can’t hold more than 5% of its total assets in the securities of any one non-REIT issuer, or own more than 10% of the voting power or value of any single issuer’s outstanding securities.² If an acquisition breaks a limit, the REIT has 30 days after the close of the quarter to dispose of the offending assets without losing status.

Income Tests

Two income tests apply each year, and the REIT has to pass both:

The 75% test: at least 75% of gross income must come from real estate sources, including rents from real property, mortgage interest, gains from selling real estate, and dividends from other REITs.²
The 95% test: at least 95% of gross income must come from those same real estate sources plus other passive income like dividends, interest, and gains from securities sales.²

Not every dollar tied to real estate qualifies. Income from services beyond what a landlord customarily provides, such as hotel restaurant operations or hands-on property management for third parties, generally isn’t rent from real property. Hospitality and healthcare REITs stumble here most often, which is one reason taxable REIT subsidiaries exist.

If a REIT fails an income test but can show reasonable cause rather than willful neglect, it can keep its status by filing a schedule of gross income with its return. A tax applies to the non-qualifying income, but the REIT is not disqualified outright.³

The 90% Distribution Requirement

This is the rule that turns the other rules into a tax benefit. A REIT must distribute dividends equal to at least 90% of its taxable income each year, calculated before the dividends paid deduction and excluding net capital gains.¹ Many REITs distribute closer to 100% to avoid any residual corporate tax.

The timing is not as tight as the numbers make it look. Dividends declared in October, November, or December and paid by January 31 of the next year are treated as if paid on December 31. Section 858 also allows a throwback election, letting distributions made before the return is filed count as paid on December 31 of the prior year.

A separate 4% excise tax under Section 4981 applies if annual distributions fall below 85% of ordinary income plus 95% of capital gain net income for the calendar year.⁴ A REIT can clear the 90% bar and keep its status while still owing the 4% excise tax on the shortfall.

How Shareholders Are Taxed

Taking tax off the REIT does not take tax off the income. It shifts to shareholders, and the character of each distribution controls the rate.

Ordinary dividends: taxed at the shareholder’s ordinary income rate. REIT dividends generally don’t qualify for the lower rates on “qualified dividends” from regular corporations, which puts many investors at a top federal rate of 37% plus the 3.8% net investment income tax.
Capital gain dividends: when a REIT designates part of a distribution as a capital gain dividend from the sale of long-held property, shareholders pay long-term capital gains rates, up to 20% plus the 3.8% surtax.¹
Return of capital: distributions that exceed current taxable income, often because depreciation sheltered part of operating income, aren’t taxed right away. They reduce the shareholder’s cost basis, so the eventual sale produces a larger taxable gain.

The 20% Deduction on REIT Dividends

Individual shareholders can deduct 20% of qualified REIT dividends under Section 199A, effectively cutting the top federal rate on ordinary REIT dividends from 37% to 29.6% before the net investment income tax. Qualified REIT dividends for this purpose are dividends that are not capital gain dividends and not qualified dividend income.⁵ The deduction had been scheduled to expire after 2025, but the One Big Beautiful Bill Act signed in July 2025 made it permanent at the 20% rate.

Unlike the deduction for other qualified business income, the piece tied to qualified REIT dividends is not subject to W-2 wage or property basis limits. Most investors take 20% off the top and pay ordinary rates on the remaining 80%.

When a REIT Still Owes Tax

Even a compliant REIT can end up with a federal tax bill. Three situations account for most of it.

Retained taxable income is taxed at the regular 21% corporate rate. A REIT that distributes exactly 90% owes corporate tax on the other 10%, which is why most REITs push distributions close to 100%.

Prohibited transactions carry a 100% tax on the net gain. Section 857 imposes it on sales of property held primarily for sale to customers in the ordinary course of business, meaning inventory-type property.¹ The IRS takes the entire profit. Statutory safe harbors, built around minimum holding periods, limits on improvement spending, and caps on the number of annual sales, protect ordinary dispositions from the label, but active developers usually route sales activity through a taxable REIT subsidiary.

Taxable REIT subsidiaries themselves are the third bucket. A TRS is a separate corporate entity that pays regular corporate tax on the income it earns from activities that would otherwise disqualify the parent’s revenue, such as hotel operations or non-customary tenant services. TRS securities can’t exceed 20% of the REIT’s total asset value.² Transactions between the REIT and its TRS have to be priced at arm’s length; if they’re not, a 100% penalty tax applies to the excess amounts under Section 857(b)(7).⁶

Losing REIT Status

A REIT that fails the organizational, ownership, asset, income, or distribution rules can lose its election. When that happens, the entity is taxed as a regular C corporation for that year and every year after, and under the general rule it cannot make a new REIT election until the fifth taxable year after the termination took effect.⁷ Five years of full corporate tax on all income is a serious hit for a business built around pass-through economics.

The code does offer savings provisions. The 30-day cure period handles asset test misses discovered after quarter-end. Income test failures can be resolved by filing the required schedule and showing reasonable cause, with a tax applied to the non-qualifying income. Other compliance failures can be cured by showing reasonable cause and paying a $50,000 penalty per failure.³ None of these are automatic. The REIT has to find the failure, disclose it, fix it, and usually pay for it, and reasonable cause is easiest to establish when a written tax opinion was in hand before the transaction that caused the problem.

1
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
2
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
3
Office of the Law Revision Counsel. 26 U.S. Code 856 – Definition of Real Estate Investment Trust
4
Office of the Law Revision Counsel. 26 U.S. Code 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts
5
Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income
6
Legal Information Institute. 26 USC 857(b)(7) – Income From Redetermined Rents, Redetermined Deductions, and Excess Interest
7
eCFR. 26 CFR 1.856-8 – Revocation or Termination of Election