REIT Compliance Rules: Ownership, Distributions, and 100% Traps

To keep its federal tax-favored status, a real estate investment trust must clear a linked set of REIT compliance rules every year: ownership tests, quarterly asset tests, annual income tests, a 90 percent distribution requirement, and the Form 1120-REIT filing that documents all of it. Miss any single test and the entity gets taxed as an ordinary corporation for that year, and neither it nor any successor can re-elect REIT treatment until the fifth taxable year after the failure.¹ That five-year lockout is what gives every other rule below its weight.

REIT status is not partial or provisional. A trust either qualifies for the full taxable year or it does not, and the initial election is made by filing it with the trust’s first income tax return.¹

Ownership Tests

The trust must be organized as a corporation, trust, or association that would otherwise be taxable as a domestic corporation, managed by at least one trustee or director, with beneficial ownership represented by transferable shares or certificates. Those structural conditions must hold for the entire taxable year.¹

The 100-Shareholder Rule

At least 100 different persons must hold beneficial ownership for at least 335 days of a 12-month taxable year, or a proportional share of a shorter year. New trusts get one exception: the rule does not apply during the first taxable year, but it must be met by January 30 of the second.¹

The 5/50 Rule

Five or fewer individuals cannot own more than 50 percent of the trust’s value during the last half of the taxable year. The rule comes in through Section 856(h)’s cross-reference to the personal holding company provisions, and it stops a small group from using the REIT form as a private tax shelter while nominally clearing the 100-person headcount.²

Shareholder Demand Letters

Because registered holders sometimes hold for others, the trust cannot rely on its own stockholding records alone. It must demand written statements from record holders identifying the actual beneficial owners. Demands go out within 30 days after the close of the taxable year, and the threshold for who receives one depends on the size of the shareholder base: trusts with 2,000 or more record holders demand statements from anyone holding 5 percent or more; trusts with 200 to 2,000 holders apply a 1 percent threshold; trusts with 200 or fewer holders apply a half-percent threshold.³ A trust that does not keep these records is taxed as an ordinary corporation regardless of whether it meets every other REIT test.

Quarterly Asset Tests

The IRS checks the portfolio at the close of every calendar quarter, not just at year-end. A large acquisition or a swing in asset values can trigger a violation in a portfolio that was clean three months earlier.

75 Percent in Real Estate

At least 75 percent of the total value of the trust’s assets must consist of real estate assets, cash and cash items (including receivables), and government securities. Real estate assets include physical property, mortgage-backed interests, and shares of other qualifying REITs. Federal regulations, not state property law, decide whether a given asset counts as real property.¹⁴

Caps on the Remaining 25 Percent

The other 25 percent of the portfolio is itself constrained. At the close of each quarter:

No more than 25 percent of total asset value in securities other than qualifying real estate assets, cash, and government securities.
No more than 20 percent of total asset value in securities of one or more taxable REIT subsidiaries.
No more than 5 percent of total asset value in the securities of any single non-TRS issuer.
No more than 10 percent of the total voting power or total value of the outstanding securities of any single non-TRS issuer.

These caps are tested every quarter.²

Annual Income Tests

Two gross income tests apply each year, and failing either one puts REIT status at risk.

The 75 percent test: at least 75 percent of gross income (excluding gains from prohibited transactions) must come from real-estate-related sources such as rents from real property, mortgage interest, gains on non-dealer real estate sales, and dividends from other REITs.¹

The 95 percent test: at least 95 percent of gross income must come from those same real-estate sources plus qualifying passive financial income such as dividends, interest, and gains from securities sales.¹ The 20-percentage-point cushion above the 75 percent floor sounds generous, but it only absorbs qualifying passive income. Service fee income, for example, does not qualify and can blow the test.

The 90 Percent Distribution Requirement

The core of the REIT bargain: to avoid entity-level tax, the trust’s dividends-paid deduction for the year must equal or exceed 90 percent of REIT taxable income, calculated before the dividends-paid deduction and excluding net capital gains.⁵

Not every dollar has to go out by December 31. Under Section 858, a dividend declared before the return’s filing deadline (including extensions) and actually paid within 12 months after the close of the taxable year can be treated as paid during that year. That gives management time to finalize the numbers before locking in a distribution.⁶

The Separate 4 Percent Excise Tax

Clearing the 90 percent hurdle keeps REIT status, but a separate excise tax kicks in at a higher threshold. Under Section 4981, the trust owes 4 percent on the shortfall between required distributions and actual distributions. The required distribution is 85 percent of ordinary income plus 95 percent of capital gain net income for the calendar year.⁷ Most trusts target distributions above the 85/95 level to avoid the excise entirely.

The 100 Percent Traps

Two situations carry a 100 percent tax rate, which means every dollar of profit or misallocation goes to the IRS.

Prohibited Transactions

Net income from prohibited transactions is taxed at 100 percent. A prohibited transaction generally means a sale of property held primarily for sale to customers in the ordinary course of business.⁵ The rule pushes REITs toward long-term ownership rather than dealer activity.

A safe harbor protects gains that meet several conditions. The property must have been held at least two years. The trust must also pass a volume test: no more than seven property sales in the year, or aggregate value (or adjusted basis) of properties sold in the year not exceeding 20 percent of total assets at the start of the year, with a three-year look-back keeping the rolling total under 10 percent. Capital improvements made during the two years before sale cannot exceed 30 percent of the selling price.

Non-Arm’s-Length TRS Dealings

A taxable REIT subsidiary is a corporation that jointly elects with the REIT to be treated as a TRS, letting the trust conduct service or non-qualifying activities without polluting its income ratios. The election is irrevocable without mutual consent, and TRS securities cannot exceed 20 percent of total asset value at any quarter close.² Rents, deductions, interest, and service fees between the trust and its TRS must be priced at arm’s length. If the IRS redetermines any of those amounts, a 100 percent excise tax applies to the redetermined portion.⁵ Contemporaneous transfer pricing documentation between a REIT and its TRS is one of the highest-priority compliance tasks in the structure.

Relief When a Test Is Missed

The code provides cure paths, but every one of them costs money.

For income test failures, the trust can keep REIT status if the failure was due to reasonable cause and not willful neglect. It files a schedule identifying each item of non-qualifying income and pays a penalty tax calculated by multiplying non-qualifying income by a fraction approximating the trust’s profitability.⁸

For asset test failures, the trust identifies the problem assets, disposes of them or otherwise comes into compliance, and files a description with its return. The penalty is the greater of $50,000 or the net income generated by the offending assets during the failure period, taxed at the highest corporate rate. A separate de minimis exception can apply to minor violations of the 5 percent or 10 percent single-issuer limits.²

For other compliance failures outside the income and asset tests, a catch-all provision preserves REIT status if the failure was due to reasonable cause, at $50,000 per violation. These relief provisions are not something to plan around, but they keep a single honest mistake from triggering the five-year disqualification.

Filing and Records

Every entity electing REIT treatment files Form 1120-REIT, the dedicated U.S. income tax return for real estate investment trusts. The return requires asset values by category, gross income broken down by source (to verify both income tests), and the dividends-paid deduction showing the 90 percent threshold was met.⁹

The return is due by the 15th day of the fourth month after the close of the taxable year. A calendar-year trust files by April 15. Trusts with a fiscal year ending in June file by the 15th day of the third month after year-end.¹⁰ Form 7004 provides an automatic six-month extension.¹¹

Beyond the annual return, the trust must keep permanent records of actual stock ownership in the IRS district where it files. The shareholder demand letters described earlier feed that record. Sending demands promptly after year-end and keeping the responses on file is one of the simplest compliance steps and one of the most commonly neglected.³

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
3
eCFR. 26 CFR 1.857-8 – Records To Be Kept by a Real Estate Investment Trust
4
eCFR. 26 CFR 1.856-10 – Definition of Real Property
5
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
6
Office of the Law Revision Counsel. 26 USC 858 – Dividends Paid by Real Estate Investment Trust After Close of Taxable Year
7
Office of the Law Revision Counsel. 26 US Code 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts
8
Office of the Law Revision Counsel. 26 US Code 856 – Definition of Real Estate Investment Trust
9
Internal Revenue Service. About Form 1120-REIT, US Income Tax Return for Real Estate Investment Trusts
10
Internal Revenue Service. Instructions for Form 1120-REIT
11
Internal Revenue Service. Instructions for Form 7004