REIT Law: Ownership Tests, Distributions, and Compliance

To qualify as a real estate investment trust under the Internal Revenue Code, an entity has to clear five sets of REIT qualification rules every year: how it is organized and how it elects, who owns it, what it holds, where its income comes from, and how much of its earnings it pays out to shareholders. Meet all of them and the entity deducts the dividends it pays and largely escapes corporate income tax. Miss one without a savings provision to fall back on, and the election terminates for the year of failure and every year after, with a five-year lockout before the entity can elect again.¹

Organizational Form and the Election

The entity must be a corporation, trust, or association that would otherwise be taxed as a domestic corporation. It has to be managed by one or more trustees or directors, and its ownership interests have to be represented by transferable shares or certificates of beneficial interest. Financial institutions and insurance companies cannot elect REIT status because they fall under separate tax regimes.¹

There is no standalone election form. The entity elects REIT status by filing Form 1120-REIT and computing its taxable income under the REIT rules for that year. Once made, the election continues for all subsequent years unless it is terminated or revoked. Unless the entity first qualified before October 5, 1976, it must use a calendar tax year. The 100-shareholder rule and the ownership concentration rule are waived for the first taxable year but apply from year two onward.²

One further gate applies at the start. The entity must either have been treated as a REIT for all tax years beginning after February 28, 1986, or have no accumulated earnings and profits from any non-REIT year.² A regular corporation that wants to convert has to distribute (and pay tax on) any leftover earnings before the election takes effect.

Ownership Tests

Two ownership rules run in parallel. Both are designed to keep the REIT from operating as a tax shelter for a small group.

The 100-Shareholder Rule

At least 100 different persons must hold beneficial ownership in the REIT. In a full 12-month year, that condition has to exist for at least 335 days; a short year is prorated.¹ The requirement does not apply in the first taxable year.

The 5/50 Rule

The REIT cannot be closely held. Using the personal holding company test from Section 542(a)(2), five or fewer individuals cannot own more than 50% of the value of the outstanding shares during the last half of the taxable year.¹ Shares held by pension funds and other qualified trusts under Section 401(a) are generally looked through to the individual beneficiaries rather than treated as owned by the trust itself, which makes the test workable for REITs with large institutional investors.

Proving compliance is a documentation exercise. Regulations require the REIT to send written demand letters to shareholders of record asking them to disclose the actual owners of the stock, and to keep the responses on file for as long as they might be relevant to the administration of any tax law.³ Skipping this step carries a $25,000 penalty, doubled to $50,000 if the failure is due to intentional disregard, unless the REIT shows reasonable cause and no willful neglect.⁴

Quarterly Asset Tests

At the close of each calendar quarter, the REIT’s portfolio has to satisfy a set of composition tests.¹

At least 75% of total asset value must be real estate assets, cash, cash items (including receivables), and government securities.
No more than 25% of total asset value may be in securities outside the 75% bucket.
Securities of one or more taxable REIT subsidiaries cannot exceed 20% of total asset value.
Outside of TRS securities and the 75% bucket, securities of any single issuer cannot exceed 5% of total asset value, and the REIT cannot hold more than 10% of the vote or 10% of the value of any one issuer’s outstanding securities.

Because measurement is quarterly rather than continuous, a mid-quarter acquisition that puts the portfolio out of balance has until the next measurement date to be corrected. Minor overages can also be cured under the savings provisions described below.

Annual Gross Income Tests

Two income thresholds apply each taxable year, both measured on gross income and both excluding gains from prohibited transactions.

Under the 75% test, at least 75% of gross income must come from real-estate-related sources: rents from real property, interest on mortgages secured by real property, gains from the sale of real estate assets, dividends from other REITs, and income from foreclosure property.¹ Rent that depends on a tenant’s income or profits generally does not count, and services to tenants have to be customary for the property type or delivered through an independent contractor or a taxable REIT subsidiary.

Under the 95% test, at least 95% of gross income must come from the 75%-test categories plus passive investment sources like dividends, interest, and gains from selling securities.¹ That leaves only a 5% window for active non-qualifying income, which is why operators watch parking, cleaning services, and similar tenant amenities closely.

Hedging income sits outside both tests. Income from interest rate swaps, caps, and similar instruments used to manage risk on real-estate-secured borrowings is excluded from gross income for purposes of the 75% and 95% calculations.¹ The IRS has extended the same treatment to offsetting hedges entered into to unwind earlier positions, subject to certain conditions.

The 90% Distribution Requirement

A REIT must distribute at least 90% of its taxable income (excluding net capital gains) to shareholders each year as dividends.⁴ Meeting that threshold unlocks the dividends-paid deduction, which is what actually eliminates corporate-level tax on the distributed portion of earnings.

Falling short is expensive in two ways. The REIT owes corporate income tax on any undistributed portion at regular corporate rates under Section 11.⁴ A separate 4% excise tax applies if actual calendar-year distributions fall below a higher benchmark: 85% of ordinary income plus 95% of capital gain net income. The excise tax is calculated on the shortfall.⁵ The two-layer penalty is why most REITs distribute aggressively rather than retain earnings.

Prohibited Transactions

A 100% tax applies to net income from prohibited transactions, meaning sales of property that would be treated as inventory held for sale to customers in the ordinary course of business.⁴ The rule keeps REITs from operating as real estate dealers while enjoying pass-through treatment. A net loss on a prohibited transaction is disallowed for computing REIT taxable income, though it does reduce the required distribution amount.

A statutory safe harbor covers routine dispositions. To qualify, the REIT must have held the property for at least two years, capital improvements in the two years before sale cannot exceed 30% of the net selling price, and generally the REIT cannot sell more than seven properties during the taxable year (with alternative asset-value-based tests for larger portfolios).⁴ For non-foreclosure property consisting of land or improvements, the two-year holding period must have been for the production of rental income. When the seven-sale limit is exceeded, substantially all marketing and development work must have been performed by an independent contractor or a taxable REIT subsidiary.

Savings Provisions When a Test Fails

The code does not automatically strip REIT status every time a test is missed. Several savings provisions let an entity keep its election and pay a penalty instead.

Income test failures: if the REIT misses the 75% or 95% test but shows reasonable cause, it keeps its status and pays a penalty tax on the excess non-qualifying income. Reasonable reliance on a written legal opinion about how income would be characterized generally satisfies the reasonable-cause standard.
Asset test failures: de minimis violations can be cured by disposing of the offending asset within six months. Larger violations trigger a tax equal to the greater of $50,000 or the product of the net income generated by the excess assets and the highest corporate tax rate.¹
Other failures: violations of structural requirements like the transferable-shares rule, the director-management rule, or the ownership concentration tests can be excused if the failure was due to reasonable cause and not willful neglect. A $50,000 penalty applies per violation.¹

Losing REIT Status

If a REIT fails a qualifying requirement and no savings provision applies, the election terminates for the year of failure and every subsequent year. Neither the entity nor any successor can re-elect REIT status until the fifth taxable year after the year the termination took effect.¹ During the lockout, the entity is taxed as an ordinary corporation on all its income with no dividends-paid deduction.

A REIT can voluntarily revoke its election for any taxable year after the first. The revocation has to be filed on or before the 90th day of the first taxable year for which it applies, and the same five-year lockout follows.¹

One narrow exception can waive the lockout. If the entity did not willfully fail to file a timely return, did not include fraudulent information, and can show the IRS that the failure to qualify was due to reasonable cause rather than willful neglect, the five-year wait does not apply.¹ The burden is on the REIT, and the Service is not obligated to agree.

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
Internal Revenue Service. Instructions for Form 1120-REIT
3
eCFR. 26 CFR 1.857-8 – Records To Be Kept by a Real Estate Investment Trust
4
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
5
Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts