How to Start a REIT: Entity, Tests, and Distributions

To start a REIT, you form an entity that would be taxable as a domestic corporation, structure its ownership and holdings to meet the IRS qualification tests, and elect real estate investment trust status by filing Form 1120-REIT for your first taxable year.¹ The entity needs at least 100 shareholders, must hold at least 75% of its assets in real estate, must earn most of its income from passive real estate sources, and must distribute at least 90% of its taxable income as dividends every year.² The concept is straightforward. Execution is where new REITs stumble.

Decide What Kind of REIT You Are Building

Two choices come before anything else: what the REIT will invest in, and how its shares will be sold.

On the investment side, equity REITs own and operate income-producing properties like office buildings, apartments, and warehouses, earning revenue from tenant rents. Mortgage REITs don’t own buildings at all. They finance real estate by buying or originating mortgages and mortgage-backed securities, earning the interest spread.

On the market side, there are three structures:

Publicly traded REITs register with the SEC and list on a national exchange. Shares trade like any other stock. Regulatory cost is highest.
Public non-listed REITs register with the SEC but don’t list on an exchange. Investors buy through broker-dealers; liquidity depends on repurchase programs or secondary marketplaces.
Private REITs skip SEC registration by selling only to institutional or accredited investors under Regulation D. Lower overhead, much smaller pool of eligible buyers.

First-time organizers usually gravitate toward private REITs because the public registration process is slow and expensive. The market structure doesn’t change the federal tax rules, though. A private REIT selling to a handful of accredited investors has to pass the same IRS tests as a REIT listed on the NYSE.

Form the Legal Entity

A REIT has to be organized as an entity that would be taxable as a domestic corporation: a standard corporation, a business trust, or an LLC that elects corporate tax treatment.³ It must be governed by a board of directors or trustees and must issue shares that are fully transferable.

Formation starts at the state level. You file articles of incorporation for a corporation, or a declaration of trust for a business trust, with the secretary of state in your chosen jurisdiction. The filing names the entity, identifies a registered agent, describes the entity’s purpose, and authorizes the shares you can issue. State filing fees for the underlying entity generally run between about $100 and $300.

If you use an LLC or limited partnership, file IRS Form 8832 to elect treatment as an association taxable as a corporation. The election must be filed within 75 days of the desired effective date and locks in your classification for five years. An LLC that doesn’t make the election defaults to partnership treatment, which disqualifies it from REIT status.

Once the state formation is complete, apply for an Employer Identification Number through the IRS. The state entity has to exist before you can apply.⁴ You will need the EIN for every tax filing, for corporate bank accounts, and for property financing.

Build Ownership That Will Pass the Shareholder Tests

Federal law imposes two ownership requirements designed to keep the trust broadly held.

The 100-shareholder rule requires at least 100 different beneficial owners for at least 335 days of each 12-month taxable year. It doesn’t apply during the first taxable year, which gives you time to build the investor base. From year two on, dropping below 100 for more than roughly a month costs you REIT status.²

The 5/50 rule prevents concentrated ownership. During the last half of each taxable year, five or fewer individuals cannot own more than 50% of the outstanding shares, directly or indirectly.² The test uses the attribution rules of Section 542(a)(2), which can count shares held by family members and related entities as belonging to a single person.⁵

Most REIT organizers write ownership restrictions directly into the articles of incorporation or trust agreement. A common provision automatically voids any transfer that would push a single investor above a set threshold, often 9.8%. Without that guardrail, a single large purchase can inadvertently disqualify the entire entity.

Pass the Asset and Income Tests

Three IRS tests make sure a REIT actually operates as a real estate investment vehicle. They are checked on an ongoing basis, and failing any of them puts your status at risk.

The 75% Asset Test

At the end of each calendar quarter, at least 75% of your total asset value has to consist of real estate, cash, and government securities. Real estate assets include land, buildings, and interests in mortgages secured by real property.³ The remaining 25% leaves room for other securities, with further caps on how much you can hold in any single issuer or in taxable REIT subsidiaries.

The 75% Gross Income Test

At least 75% of your gross income each year has to come from real estate sources: rents from real property, interest on mortgage-backed obligations, and gains from selling real estate assets.³ This is where passive real estate income has to be distinguished from active business income. Fees for services provided to tenants can fall outside what qualifies.

The 95% Gross Income Test

At least 95% of your gross income has to come from the sources that qualify under the 75% test plus dividends, interest, and gains from selling securities.³ Only a small sliver of revenue can come from sources unrelated to real estate or financial investments.

Classification errors on the income tests are the most common way new REITs fail. A property management fee that looks like ordinary real estate income can fail to qualify if it involves impermissible tenant services. Accounting systems that flag questionable income during the year, rather than at year-end, are worth the investment.

Plan the 90% Distribution Requirement

The defining tax advantage of a REIT is avoidance of corporate-level income tax on profits it distributes. To get the benefit, the trust must pay out dividends equal to at least 90% of its taxable income each year, excluding net capital gains.⁶ Those dividends are deducted from taxable income, so the entity pays little or no federal corporate tax, and the liability shifts to the shareholders who receive the dividends.

Meeting the 90% minimum doesn’t guarantee you avoid penalties. A separate 4% excise tax applies if your distributions fall short of 85% of ordinary income and 95% of capital gain net income for the calendar year.⁷ The excise tax applies to the gap between the required distribution and what you actually paid. Most REITs distribute above 90% to steer clear of it.

The practical problem is that distributions are measured against taxable income, which doesn’t always match cash flow. A property can produce accounting income through depreciation recapture while generating negative cash from capital expenditures. REITs typically model distribution obligations quarterly and hold cash reserves or credit lines to cover timing gaps.

Elect REIT Status by Filing Form 1120-REIT

There is no separate application for REIT status. You claim it by filing IRS Form 1120-REIT, the U.S. Income Tax Return for Real Estate Investment Trusts, for your first taxable year. Filing the form is treated as your election.¹ The election covers the entire taxable year and stays in effect for later years unless the entity loses its qualification or revokes.

The deadline is the 15th day of the fourth month after the end of your tax year — April 15 for a calendar-year REIT.¹ Most REITs must use a calendar year. To complete the return you need precise figures for gross rents, interest income, and capital gains, a shareholder list showing holdings, and calculations proving you passed the asset and income tests for every quarter.⁸

SEC Registration for Public REITs

If you plan to offer shares to the general public, you must register with the Securities and Exchange Commission. REITs use Form S-11, the registration statement built for real estate companies and investment trusts.⁹ The filing requires detailed disclosure of the business plan, property portfolio, financial condition, and risk factors. Once the SEC declares it effective, you can list on a national exchange.

Private REITs skip SEC registration by relying on Regulation D, which limits sales to accredited and institutional investors. Public non-listed REITs file a registration statement but don’t list. None of these paths change the IRS qualification requirements.

State-Level Compliance

After the federal election, most states require annual reports with the secretary of state and payment of franchise taxes or registration fees, which vary widely. These filings keep the entity in good standing to hold property and do business. Lenders and title companies will refuse to close transactions with an entity that has lapsed at the state level.

Use a Taxable REIT Subsidiary for Activities That Would Break the Tests

Some activities valuable to a real estate business would break the income tests if the REIT performed them directly. Operating a hotel, running a healthcare facility, or providing non-customary tenant services all generate active business income that doesn’t qualify under the 75% or 95% tests. The fix is a taxable REIT subsidiary, or TRS.

A TRS is a corporation owned by the REIT that jointly elects TRS status with its parent. The subsidiary pays regular corporate income tax on its earnings, but the parent REIT can own it without those active revenues contaminating the income tests. Hotels are the classic example: the REIT owns the building, the TRS operates the hotel business.

There is a size cap. For taxable years beginning in 2026 and beyond, no more than 25% of total asset value can consist of TRS securities.⁵ Exceeding it is an asset test failure, so TRS value has to be monitored every quarter.

A qualified REIT subsidiary (QRS), separately, is a corporation 100% owned by the REIT that is invisible for tax purposes. Its assets, liabilities, and income are treated as belonging directly to the parent.⁵ REITs use QRS entities to hold individual properties for liability isolation without filing separate returns or complicating the income tests.

Avoid Prohibited-Transaction Treatment on Property Sales

The IRS draws a hard line between a REIT that sells investment property and a REIT that acts as a real estate dealer. If you buy properties primarily to flip them, the gains are classified as prohibited transactions and taxed at 100%.⁶ Not 100% on top of regular tax. The full net income from the sale goes to the IRS.

To protect REITs that need to sell assets as part of normal portfolio management, the tax code provides safe harbors. If a sale meets the criteria, it won’t be treated as a prohibited transaction regardless of what the IRS thinks about intent. The main requirements:

You held the property for at least two years and it produced rental income during that time.
Improvements made in the two years before sale didn’t exceed 30% of the sales price.
You sold no more than seven properties during the taxable year, or the total value sold didn’t exceed 20% of total asset value, with additional rolling three-year lookback provisions.

If you exceed the seven-sale threshold, the safe harbor is still available, but substantially all marketing and development work on the sold properties has to have been done through an independent contractor or your TRS. The rules are technical, so plan disposition strategy well before any property is listed.

Keep Status: Cures and the Cost of Losing It

The IRS built relief valves into the REIT rules because the tests are strict enough that accidental violations happen to well-run organizations.

If you fail the 75% or 95% gross income test but the failure was due to reasonable cause rather than willful neglect, you can keep REIT status by disclosing the failure on your tax return and paying a penalty tax calculated on the shortfall.⁶ You pay a financial penalty instead of losing status outright.

For small violations of the asset diversification rules, where the excess asset is worth less than $10 million or 1% of total assets, whichever is smaller, you have six months from the end of the quarter in which you discover the violation to fix it, with no penalty. For larger violations, you still get a six-month cure period but owe a tax equal to the greater of $50,000 or the net income from the excess assets multiplied by the highest corporate tax rate.

If a test fails and can’t be cured, the REIT election terminates. The entity becomes a regular C corporation subject to 21% federal corporate tax, with no dividends-paid deduction, and shareholders lose the pass-through benefit. After termination, the entity cannot re-elect REIT status for five taxable years.³

A narrow exception exists: if the failure wasn’t willful, the return was filed on time, and you can demonstrate reasonable cause, the five-year lockout may not apply.³ Reasonable cause is a high bar, and the argument gets made after the damage is done. Quarterly asset valuations, real-time income tracking, and regular shareholder census reports are what keep problems small enough to cure.

1
Internal Revenue Service. Instructions for Form 1120-REIT
2
U.S. Securities and Exchange Commission. Investor Bulletin: Real Estate Investment Trusts (REITs)
3
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
4
Internal Revenue Service. Employer Identification Number
5
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
6
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
7
Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts
8
Internal Revenue Service. U.S. Income Tax Return for Real Estate Investment Trusts
9
Securities and Exchange Commission. Form S-11 – For Registration Under the Securities Act of 1933