A real estate investment trust must distribute at least 90% of its taxable income to shareholders each year to keep its pass-through tax treatment under the REIT 90% distribution rule. The threshold sits in Section 857(a)(1), and it is calculated on taxable income figured without regard to net capital gains and before the dividends-paid deduction.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries Distribute at least that much, and the trust escapes corporate-level tax on the distributed portion. Fall short, and the consequences range from a $50,000 penalty to loss of REIT status entirely.
What the 90% Applies To
The 90% is measured against REIT taxable income, not gross rents and not cash collected. That figure starts from regular corporate taxable income and is adjusted under Section 857(b)(2). Net capital gains come out, so the floor rides on ordinary operating income only; the trust can still distribute capital gains, but those gains do not raise the minimum it must pay. Net income from foreclosure property is excluded and taxed separately. REITs cannot claim the dividends-received deduction that ordinary corporations use. Net operating losses carry forward indefinitely but cannot be carried back.2Internal Revenue Service. Instructions for Form 1120-REIT
The dividends-paid deduction is what makes the pass-through work: the trust subtracts what it pays out to shareholders from taxable income, so income it distributes is not taxed at the entity level.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries Note the order: the 90% test is applied to taxable income calculated before that deduction. The deduction then wipes out the tax on the distributed portion once you have satisfied the test.
Why Depreciation Makes the Rule Easier to Meet
Real estate throws off a lot of non-cash deductions. Depreciation and amortization cut taxable income without any cash going out the door. A trust that collects $10 million in rent and books $3 million in depreciation has $7 million of taxable income for distribution purposes, even though the full $10 million sits in the bank.
Because the 90% floor rides on the smaller accounting number, the trust can meet the rule and still retain meaningful cash for acquisitions, capital improvements, and debt service. Many REITs distribute well above the minimum because the cash is there and higher payouts attract investors. The 90% is a floor on the ratio of distributions to taxable income, not a ceiling on the trust’s operating flexibility.
Which Distributions Count
Section 561 defines the dividends-paid deduction as dividends actually paid during the year plus consent dividends, along with certain carryover amounts for personal holding companies.3Office of the Law Revision Counsel. 26 USC 561 – Definition of Deduction for Dividends Paid In practice, REITs have four ways to satisfy the 90%.
Cash dividends. The straightforward path. Paid in the taxable year, deducted on that year’s return.
Consent dividends. The trust reports the amount, shareholders agree to be taxed as if the money had been distributed and reinvested, and no cash actually moves. Useful when liquidity is tight, but it requires shareholder cooperation.
Stock dividends. These can qualify, but only under specific conditions. For publicly offered REITs, Revenue Procedure 2017-45 requires shareholders to have a real cash election, with aggregate cash available to electing shareholders equal to at least 20% of the total distribution.4Internal Revenue Service. Revenue Procedure 2017-45 A pure stock distribution with no cash option will not satisfy the dividends-paid deduction.
Spillover dividends. Section 858 lets a trust declare a dividend before the filing deadline for its return (including extensions), pay it within 12 months after year-end and no later than the first regular dividend payment following the declaration, and elect on the return to treat it as a prior-year distribution.5Office of the Law Revision Counsel. 26 USC 858 – Dividends Paid by Real Estate Investment Trust After Close of Taxable Year Calendar-year REITs file Form 1120-REIT by April 15, with an automatic extension available on Form 7004, so that filing deadline effectively caps how late a spillover dividend can be declared.6Internal Revenue Service. Instructions for Form 1120-REIT
What Happens If a REIT Falls Short
Missing the 90% floor does not automatically end REIT status. If the shortfall is due to reasonable cause and not willful neglect, the trust can preserve its qualification by paying a $50,000 penalty for each failure.6Internal Revenue Service. Instructions for Form 1120-REIT Without that exception, the trust loses REIT status and pays ordinary corporate income tax on all earnings.
When an audit or later determination reveals that a prior year was underdistributed, Section 860 offers a deficiency dividend procedure. The trust pays the corrective dividend within 90 days of the determination and files a claim for the deficiency dividend deduction on Form 976 within 120 days, attaching a certified copy of the board resolution authorizing the payment and documentation of how the deficiency was established.7eCFR. 26 CFR 1.860-2 – Requirements for Deficiency Dividends The trust does not have to distribute the full adjustment; it can pay a smaller deficiency dividend and accept corporate tax on the remainder.
Whatever the trust does not distribute is taxed at the 21% corporate rate.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries Retention can fund capital projects or build reserves, but the tax cost usually makes it a poor source of funding.
The 4% Excise Tax Is a Separate Threshold
Meeting the 90% income test does not necessarily avoid the excise tax. Section 4981 imposes a 4% excise on the gap between actual distributions and a calendar-year required distribution equal to 85% of the trust’s ordinary income plus 95% of its capital gain net income, increased by any shortfall carried over from the prior year.8Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts The 85%/95% figures are deliberately higher than the 90% income test, and they apply on a calendar-year basis. A trust can clear the 90% rule and still owe excise tax if distributions are back-loaded or poorly timed within the year.
What the 90% Rule Does Not Cover
Two other REIT taxes sometimes get folded into the distribution conversation but sit outside it. Prohibited transactions — sales of property treated as inventory held for sale to customers in the ordinary course of business — are taxed at 100% of the net income from the sale, meaning the trust keeps nothing.1Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries Safe harbors protect routine dispositions when the trust makes no more than seven sales of non-foreclosure property during the year, or when the aggregate value or adjusted basis of properties sold does not exceed 10% of total assets at the start of the year. And the reasonable-cause relief under Section 856(g)(5), also carrying a $50,000 penalty per failure, addresses other qualification failures such as inadvertent breaches of the asset or ownership tests, which are governed by their own cure provisions rather than by the 90% rule.6Internal Revenue Service. Instructions for Form 1120-REIT Neither of those regimes can be satisfied by paying more dividends.