Reg REIT Requirements: Income, Asset, and Distribution Tests

To qualify as a real estate investment trust under federal tax law, an entity has to meet a continuous set of REIT requirements covering its structure, who owns it, where its income comes from, what sits on its balance sheet, and how much of its earnings it pays out each year. The rules live mostly in Sections 856 and 857 of the Internal Revenue Code, and they are tested on an ongoing basis: annually for income and distributions, quarterly for assets, and across the full tax year for ownership. Miss any of them and the entity can lose its pass-through tax status, get taxed as a regular C corporation, and be barred from re-electing REIT treatment for five years.

Structure and Ownership Rules

A REIT has to be a corporation, trust, or association that would otherwise be taxed as a domestic corporation. It needs at least one director or trustee, its ownership interests must be represented by transferable shares or certificates, and it cannot be a bank or an insurance company.¹

Two ownership rules keep REITs from functioning as private investment vehicles. The 100-shareholder rule requires at least 100 different people to hold beneficial ownership. A REIT does not have to meet this threshold in its first tax year, but after that the test has to be satisfied for at least 335 days of a 12-month taxable year.¹

The second is the closely-held test, often called the 5/50 rule. During the last half of the taxable year, five or fewer individuals cannot own more than 50% of the REIT’s outstanding shares. The test uses personal holding company attribution rules, so indirect and constructive ownership counts.²

To monitor these limits, every REIT has to send annual demand letters to specified shareholders of record within 30 days after the close of the tax year, asking for written disclosure of their actual and constructive ownership. A failure carries a $25,000 penalty, rising to $50,000 if intentional, waivable for reasonable cause.

Income Tests

Two income thresholds, tested annually against gross income, keep a REIT focused on real estate rather than operating businesses.

Under the 75% test, at least 75% of gross income has to come from a narrow set of real-estate-related sources: rents from real property, interest on mortgage-backed obligations, gains from selling real estate that is not dealer property, dividends from other qualified REITs, income from foreclosure property, and certain loan commitment fees.¹

Under the 95% test, at least 95% of gross income has to come from those same sources plus broader passive investment income: dividends from non-REIT stocks, interest from non-real-estate sources, and gains on securities sales. In practice, no more than 5% of a REIT’s gross income can come from active business operations or other nonqualifying activity.¹

What Counts as Qualifying Rent

Rental income is the backbone of most equity REITs, and three categories of rent are automatically excluded from “rents from real property.”

Rent tied to a tenant’s income or profits does not qualify. A percentage of gross receipts is acceptable; a percentage of net profits is not.¹

Rent from a tenant in which the REIT owns 10% or more (by vote or value for corporations, or by asset or profit interest for other entities) does not count. The transaction is not arm’s-length, so the income is not treated as qualifying.

Impermissible tenant service income is the trap REITs fall into most often. If the REIT directly furnishes services to tenants beyond what is customary for the property type, income from those services is not qualifying rent. When impermissible service income from a single property exceeds 1% of all amounts received from that property during the year, the entire rental stream from that property is disqualified.¹

The usual workaround is to route non-customary services through an independent contractor from whom the REIT earns no income, or through a taxable REIT subsidiary. That is how hotel and healthcare REITs run active-management properties without breaking the income tests.

Asset Tests

Portfolio composition is tested at the close of each calendar quarter. At least 75% of total assets must consist of real estate assets, cash, and government securities. Real estate assets include real property, mortgage loans, interests in other REITs, and certain mortgage-backed securities. That leaves no more than 25% of the portfolio for everything else.¹

Assets outside the 75% bucket face three concentration limits:

No single issuer’s securities can exceed 5% of the REIT’s total assets.
The REIT cannot own more than 10% of any single issuer’s outstanding voting securities.
The REIT cannot hold securities whose value exceeds 10% of the total value of all outstanding securities of any single issuer.

These limits do not apply to government securities, shares in other qualified REITs, or securities already counted in the 75% bucket. They also do not apply to taxable REIT subsidiaries, though total TRS securities cannot exceed 20% of the REIT’s total assets.¹

If a quarter-end check turns up a failure, the REIT has 30 days after the close of that quarter to cure it by selling the offending securities, acquiring additional qualifying assets to shift the ratios, or taking other corrective action. No penalty applies if the cure is completed in time. The grace period has saved more than a few REITs from accidental failures triggered by market swings or asset revaluations.

The 90% Distribution Requirement

The rule that most directly preserves pass-through treatment is the mandatory annual distribution. The REIT’s dividends-paid deduction has to equal or exceed 90% of its REIT taxable income, calculated before the dividends-paid deduction itself and excluding net capital gain. Retained income, up to the 10% the REIT is allowed to keep, gets taxed at regular corporate rates. Falling short of the 90% threshold means the REIT provisions do not apply for that year at all, and the entity is taxed as a regular corporation.³

A separate 4% excise tax under Section 4981 applies to the shortfall between what the REIT was required to distribute within the calendar year and what it actually distributed. The required distribution is 85% of ordinary income plus 95% of net capital gains, with any prior-year shortfall added on top. The excise tax is due by March 15 of the following year.⁴

So two distribution hurdles run in parallel. The 90% test under Section 857 decides whether the REIT keeps its tax status. The 85%/95% test under Section 4981 decides whether it owes the 4% excise. Year-end planning has to clear both.

A spillover dividend offers some relief at the margin: a REIT can declare a dividend in the current tax year, pay it early in the following year, and have it count toward the prior year’s distribution requirement, as long as the dividend is declared before the tax return filing deadline and actually paid within 12 months.

Prohibited Transactions

Selling property held primarily for sale to customers in the ordinary course of business triggers a 100% tax on the net income from that sale. The penalty exists to stop REITs from flipping property like dealers.³

A statutory safe harbor protects a sale from the 100% tax if all of the following conditions are met:

The REIT held the property for at least two years and used it to produce rental income during that time.
Total capital expenditures during the two years before the sale did not exceed 30% of the net selling price.
The REIT sold no more than seven properties during the tax year, or the total adjusted basis (or fair market value) of all properties sold did not exceed 10% of the REIT’s aggregate asset base at the start of the year.
If the seven-property limit is exceeded, substantially all marketing and development expenses were handled by an independent contractor or a taxable REIT subsidiary.

Falling outside the safe harbor does not automatically make a sale a prohibited transaction. It just means the question gets decided on a facts-and-circumstances analysis of whether the REIT was really acting as a dealer.

What Happens If a REIT Fails a Test

Losing REIT status is the worst case, and the code provides graduated remedies that let a REIT fix most problems without that outcome. The remedy depends on which test was broken.

A REIT that fails the 75% or 95% income test can keep its status if the failure was due to reasonable cause rather than willful neglect. It has to disclose the failure on its return and pay a penalty tax equal to the nonqualifying income multiplied by a fraction approximating the REIT’s overall profitability.

Asset test failures beyond the 30-day cure period get their own relief. A de minimis violation of the 5% or 10% tests carries no penalty. Larger violations can be cured by correcting the failure, disclosing it, and paying a penalty equal to the greater of $50,000 or the net income from the excess assets multiplied by the highest corporate tax rate.¹

For violations of the non-income, non-asset requirements (the 100-shareholder rule, the closely-held test, the transferable shares requirement, or the board-of-directors rule), a REIT that demonstrates reasonable cause pays a flat $50,000 penalty per violation and keeps its status.

If none of the savings provisions apply and status is actually lost, the entity and any successor are barred from re-electing REIT treatment until the fifth taxable year after the termination took effect. The lockout does not apply if the REIT can show the failure resulted from reasonable cause, the return was timely filed, and no fraud was involved.¹

Reasonable cause in any of these contexts usually means documented compliance procedures, regular reviews, and reliance on tax counsel for ambiguous calls. Retroactive claims of good faith without documentation rarely succeed.

How Shareholders Are Taxed on REIT Distributions

Because the REIT deducts the dividends it pays, distributed income escapes tax at the entity level and is taxed to shareholders instead, reported on Form 1099-DIV. Distributions fall into three categories.⁵

Ordinary income dividends are the largest portion of most REIT payouts and are taxed at your regular marginal rate. Under Section 199A, non-corporate taxpayers can deduct up to 20% of qualified REIT dividends, effectively capping the top rate on this income below the top ordinary rate. The One Big Beautiful Bill Act, signed in 2025, made this deduction permanent.⁶⁷

Capital gain dividends come from the REIT’s sale of property held more than a year and are taxed at long-term capital gains rates.

Return-of-capital distributions exceed the REIT’s current and accumulated earnings and profits. You do not owe tax on them when received; they reduce your cost basis in the shares instead. If your basis reaches zero and distributions continue, the excess is taxed as a capital gain.

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
U.S. Securities and Exchange Commission. Investor Bulletin – Real Estate Investment Trusts (REITs)
3
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
4
Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts
5
Internal Revenue Service. Form 1099-DIV – Dividends and Distributions
6
Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income
7
Internal Revenue Service. Qualified Business Income Deduction