REIT Qualifications: Ownership, Asset, and Income Tests

To qualify as a Real Estate Investment Trust, a company must satisfy the organizational, ownership, asset, income, and distribution requirements set out in Internal Revenue Code Section 856 and distribute at least 90 percent of its taxable income to shareholders each year. Meeting the full set of REIT qualification requirements lets the entity avoid corporate-level tax on the income it passes through. Missing any of them, without a timely cure, means the company is taxed as an ordinary corporation and generally cannot re-elect REIT status for five years.

Organizational Requirements

A REIT has to be an entity that would otherwise be taxable as a domestic corporation. Traditional corporations, limited partnerships, LLCs, and business trusts all work, provided they are formed in one of the 50 states or the District of Columbia. At least one director or trustee has to manage the entity, and its shares or certificates of beneficial interest must be freely transferable.¹

The company elects REIT status by filing IRS Form 1120-REIT with its tax return. Because the form isn’t due until March, the election is made after the end of the first taxable year as a REIT. A REIT must use a calendar year. Once the election is in place, it continues automatically unless the company voluntarily revokes it or fails a qualification test.²

Ownership Tests

100 Shareholders

Starting with its second taxable year, a REIT must have at least 100 shareholders. The rule exists to keep a few investors from forming a private vehicle and claiming pass-through treatment Congress designed for broadly held pools.³

The 5/50 Rule

During the last half of each taxable year, five or fewer individuals cannot own more than 50 percent of the REIT’s outstanding shares. The IRS reads “individuals” broadly to include certain trusts and private foundations, so splitting ownership across related entities doesn’t easily avoid the limit.³

Shareholder Recordkeeping and Demand Letters

Under Treasury Regulation Section 1.857-8, every REIT must keep records of who owns its stock and must send annual demand letters to certain shareholders requesting written confirmation of ownership. Those letters have to go out within 30 days after the close of the tax year. Which shareholders get them depends on the size of the shareholder base:

If there are 2,000 or more shareholders of record, demand from each holder of 5 percent or more of the stock.
If there are 201 to 1,999 shareholders, demand from each holder of 1 percent or more.
If there are 200 or fewer shareholders, demand from each holder of 0.5 percent or more.

The penalty for failing to keep the records or send the letters is $25,000, rising to $50,000 if the failure is intentional. The penalty can be waived for reasonable cause.

Asset Tests

The IRS checks the composition of a REIT’s portfolio at the end of each calendar quarter. The point is to confirm that the entity is genuinely in the real estate business.

75 Percent in Real Estate Assets

At least 75 percent of total assets must consist of real estate assets, cash, cash items, and government securities. Real estate assets include land, buildings, mortgages secured by real property, and shares in other qualified REITs.¹

5 Percent and 10 Percent Concentration Limits

For the assets outside the real estate bucket, no more than 5 percent of total assets can be invested in the securities of any single issuer. The REIT also cannot hold securities representing more than 10 percent of either the voting power or the total value of any one issuer’s outstanding securities. These limits stop a REIT from functioning as a holding company for a non-real-estate business.¹

Taxable REIT Subsidiary Cap

REITs often need to generate income that wouldn’t qualify under the gross income tests, such as hotel operations or tenant services. That income can be run through a taxable REIT subsidiary (TRS), a corporation owned directly or indirectly by the REIT that has jointly elected TRS treatment. The TRS pays regular corporate income tax (currently 21 percent) on its earnings. Securities of TRSs cannot exceed 20 percent of the REIT’s total assets at the end of any quarter, so an acquisition that shifts the asset mix can push a REIT over the limit quickly.

Curing an Asset Test Failure

A REIT that trips an asset test at quarter-end has a 30-day savings provision: dispose of the nonqualifying assets within 30 days of the quarter’s close and no failure is treated as having occurred. This cure doesn’t require proving reasonable cause and carries no penalty, which makes it the first line of defense when market movements or a single acquisition shift portfolio percentages.

Income Tests

75 Percent Real Estate Income

At least 75 percent of gross income must come from real estate sources. Qualifying income includes rents from real property, mortgage interest, gains from selling real estate, dividends from other REITs, and refunds of real property taxes.¹

95 Percent From Real Estate Plus Passive Investment Income

At least 95 percent of gross income must come from the real estate sources above plus passive investment income such as dividends, interest, and gains from securities sales. That leaves a 5 percent cushion for income that fits neither category. Both tests exclude income from prohibited transactions.¹

Income from hedging transactions, such as interest rate swaps used to manage risk on debt incurred to acquire real estate, is excluded from gross income for both tests under IRC Section 856(c)(5)(G). The exclusion also covers counteracting hedges entered when terminating the original hedge isn’t commercially practical, as long as the hedges are properly identified and don’t exceed the notional amounts being hedged.

Reasonable Cause Relief

Missing the 75 percent or 95 percent test doesn’t automatically end REIT status. If the failure was due to reasonable cause rather than willful neglect, and the REIT discloses it to the IRS, status can be preserved but a penalty tax applies. The tax equals the greater of the shortfall under the 95 percent test or the shortfall under the 75 percent test, multiplied by a fraction reflecting the REIT’s profitability. Documenting reasonable cause is what keeps the entity out of the much worse outcome of outright disqualification.

The 90 Percent Distribution Requirement

Each year, a REIT must distribute at least 90 percent of its taxable income to shareholders as dividends. Retained income is taxed at regular corporate rates, so the incentive to distribute is strong.³

A separate 4 percent excise tax under IRC Section 4981 applies when a REIT under-distributes. The tax hits the gap between what the REIT was required to distribute (roughly 85 percent of ordinary income plus 95 percent of capital gain net income for the calendar year) and what it actually distributed. The excise tax is due by March 15 of the following year.⁴

The 4 percent excise tax is a warning shot. A REIT that fails to meet the 90 percent threshold itself risks losing tax-advantaged status entirely and being taxed as an ordinary C corporation on all income.

Prohibited Transactions

A REIT is treated as an investor, not a dealer. If the IRS decides a REIT is buying and flipping properties like a developer, the profits from those sales are hit with a 100 percent tax, effectively confiscating the gain.

A statutory safe harbor shields qualifying sales. The property must have been held for at least two years, and capital expenditures during the two years before sale cannot exceed 30 percent of the sale price. Additional safe harbor conditions limit the number of property sales a REIT can make in a given year. Meeting these thresholds doesn’t guarantee a sale will be treated as investment activity, but it creates a strong presumption against dealer characterization.

What Happens If a REIT Fails to Qualify

If a company fails any qualification test and can’t cure the failure, it loses its REIT election. All income then faces corporate-level tax, wiping out the pass-through benefit. The longer-term penalty is often more painful: a company that loses REIT status generally cannot re-elect for five taxable years following the year of disqualification, unless the IRS grants relief by finding the failure was due to reasonable cause and not willful neglect.

That five-year lockout is why REITs invest heavily in quarterly asset test tracking, the shareholder demand letter process, and documentation to support reasonable cause if something slips. An accidental miss is survivable within the cure windows. A pattern of neglect can shut the door on REIT treatment for years.

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
U.S. Securities and Exchange Commission. Investor Bulletin: Real Estate Investment Trusts (REITs)
4
Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts