REIT Income Test: The 75% and 95% Gross Income Rules

To keep its pass-through tax treatment, a real estate investment trust must satisfy two annual gross income tests: at least 75% of gross income has to come from real estate sources, and at least 95% has to come from passive sources such as rent, interest, and dividends.¹ These are the REIT income tests under IRC Section 856(c), and both must be met every year. Miss one and the REIT can still cure the failure with a penalty tax if it acted with reasonable cause; miss badly or willfully and the entity loses REIT status for at least five years.

The 75 Percent Test: Real Estate Income

The stricter test is the one that defines the entity as a real estate vehicle. At least 75% of gross income each year must come from a specific list of real estate-related sources:¹

Rents from real property (the largest category for most equity REITs, and the one with the most detailed exclusions).
Interest on obligations secured by mortgages on real property or on interests in real property.
Gains from selling real property that wasn’t held primarily for sale to customers.
Dividends from other qualified REITs and gains from selling their shares.
Income and gains from foreclosure property.
Commitment fees for agreeing to make real property loans or to purchase or lease real property, provided the fee doesn’t depend on anyone’s income or profits.
Abatements and refunds of real property taxes.
Qualified temporary investment income earned during a one-year window after a capital raise.

That last category gives a REIT room to hold newly raised money in short-term investments while it lines up property acquisitions. Interest and dividends earned on the proceeds of a stock offering (other than dividend reinvestment plan proceeds) or a public debt offering with maturities of at least five years count toward the 75% test for one year after the raise.¹ Without it, a REIT that closed a large equity offering in December could fail the test the following quarter while acquisitions were still pending.

The 95 Percent Test: Passive Income

The 95% test casts a much wider net. Everything that qualifies under the 75% test also qualifies here, plus several additional categories that have nothing to do with real estate:³

Dividends from any source, including ordinary C-corporations with no real estate connection.

Interest of any kind, including money market funds, Treasury securities, and commercial paper.

Gains from selling stocks and securities.

The remaining 5% of gross income can come from almost any source, including fee income or active business revenue.

The two tests operate independently. A REIT can pass one and fail the other. If real estate sources produce only 70% of gross income while all passive sources combined produce 96%, the 75% test fails and the 95% test passes. Both have to be satisfied in the same year.

What Counts as Rent from Real Property

Rent is where most equity REITs get their qualifying income, and it is also where the statutory definition diverges most sharply from the ordinary meaning of the word. Several kinds of payments that look like rent don’t count, and crossing certain thresholds can disqualify all income from a property rather than just the offending portion.

Rent Tied to Tenant Profits

Rent that varies with a tenant’s net income or profits is excluded from the definition of qualifying rent.2Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust The rule stops a REIT from effectively sharing in a tenant’s business results.

Percentage rent is still allowed if it’s based on the tenant’s gross receipts or sales, which is common in retail leases (base rent plus a percentage of sales above a threshold). Gross receipts qualify; net profits do not. Lease formulas that blur the line are where REITs run into trouble.

The 10 Percent Related-Party Rule

Rent from a related tenant does not qualify. A REIT is treated as related to a tenant if it directly or indirectly owns:¹

10% or more of the total combined voting power of all classes of voting stock, or 10% or more of the total value of all classes of stock, in a corporate tenant; or
10% or more of the assets or net profits of a non-corporate tenant.

The test picks up both direct and indirect ownership, so layered structures do not sidestep it.

Impermissible Tenant Services

Rent doesn’t qualify if the REIT furnishes services to tenants beyond what is customary for the property type in that market.¹ Maintaining common areas, running elevators, and providing basic building security at an office tower is customary. A concierge desk, catering, or specialized IT support usually is not. The line is fact-specific.

The consequence of crossing it is unforgiving. If impermissible service income from a property exceeds 1% of the total the REIT receives from that property for the year, all of the REIT’s service income from that property is treated as impermissible.¹ The all-or-nothing design pushes REITs to keep non-customary services well below the ceiling.

Two workarounds exist. Services provided through an independent contractor from whom the REIT derives no income don’t count as REIT-provided services. Neither do services provided through a taxable REIT subsidiary.¹ Large REITs typically route any non-customary service operation through a taxable REIT subsidiary so the rent the parent collects stays clean. The subsidiary pays corporate tax on its own income.

Personal Property Under the Same Lease

When personal property (furniture, equipment, fixtures) is leased along with real property under the same lease, rent attributable to the personal property can still count as rent from real property. The personal property portion cannot exceed 15% of the total rent under that lease for the year, measured by the ratio of fair market values of personal and real property at the beginning and end of the year.⁴

Qualifying Mortgage Interest

For mortgage REITs, interest on loans secured by real property is the main 75% source. The obligation has to be secured by real property or an interest in real property.2Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust Interest on unsecured loans or loans backed only by personal property fails the 75% test, though it still counts as general interest under the 95% test.

The same profit-participation restriction that applies to rent applies here. Qualifying mortgage interest cannot depend on the borrower’s net profits, but it can vary with the borrower’s gross receipts or sales. Both equity and mortgage REITs are bound to the same principle: income can scale with a property’s top line, not its bottom line.

How Hedging Income Is Treated

Income from qualifying hedging transactions is excluded from gross income entirely for both the 75% and 95% tests.¹ Hedging gains don’t help the ratio, but they don’t hurt it either. They come out of both the numerator and denominator.

To get this treatment, the hedge must manage interest rate risk on debt the REIT incurred or will incur to acquire or carry real estate assets, or currency risk on qualifying income or the property producing it. The REIT also has to identify the transaction properly under the tax code’s hedging identification rules.

When a REIT partially unwinds a hedge because full termination would be commercially impractical, income from the offsetting counteracting transaction also qualifies for exclusion. That prevents a REIT from having to choose between steep termination fees and non-qualifying income that would jeopardize its status.

What Happens If a REIT Fails a Test

Failing the 75% or 95% test doesn’t automatically end REIT status. The code provides a cure, but only if two things are true: the failure was due to reasonable cause and not willful neglect, and the REIT files a schedule with its return listing every item of gross income in the categories relevant to the failed test.¹

If both conditions are met, the REIT stays qualified but owes a penalty tax. The penalty is based on the greater of two shortfall amounts:⁵

95% of gross income minus the amount actually derived from 95%-qualifying sources, or
75% of gross income minus the amount actually derived from 75%-qualifying sources.

The larger shortfall is then multiplied by a profitability fraction (roughly, taxable income divided by gross income, with adjustments for capital gains and foreclosure property) to approximate how much profit the non-qualifying income actually produced. The result is the penalty owed. For a REIT with healthy margins that missed by a wide margin, the bill can be significant, but it is far less costly than losing REIT status.

Loss of REIT Status

If the failure was willful, reasonable cause can’t be shown, or the required income schedule isn’t filed, the REIT election terminates. The entity is taxed as a regular C-corporation for the failure year and every year after, unless it re-elects.¹

After a termination or voluntary revocation, the entity generally can’t re-elect REIT status until the fifth taxable year beginning after the year the termination took effect.¹ That means at least five years of double taxation: corporate tax at the entity level and individual tax on any dividends. For a structure designed to avoid exactly that outcome, five years is severe.

One narrow exception waives the five-year wait if the termination wasn’t caused by willful neglect, the REIT timely filed its return for the failure year without fraud, and the failure was due to reasonable cause.¹ Meeting this standard after the income-test cure has already failed is a hard argument, because the cure required the same reasonable cause showing in the first place.

The Distribution Requirement Sits Alongside the Income Tests

The income tests are not the only thing REIT status depends on. A REIT must also distribute at least 90% of its taxable income (with certain adjustments) as dividends each year.⁵ Missing the distribution requirement jeopardizes REIT status on its own, regardless of the income tests.

The interaction is worth noticing. A REIT can pass both income tests and still lose its status by retaining too much taxable income for reinvestment or reserves. The tax code enforces the same purpose from two angles: earn the right kind of income, and pay it out.