A taxable REIT subsidiary, commonly called a TRS, is a regular C corporation owned by a real estate investment trust that handles business activities the REIT cannot perform directly without jeopardizing its tax-favored status. The TRS pays the standard 21% federal corporate income tax on its own earnings,1Office of the Law Revision Counsel. 26 U.S. Code 11 – Tax Imposed which is the price the REIT pays to keep its pass-through structure intact while still running hotels, developing property for sale, or offering tenants services that go beyond standard building maintenance.
Why a REIT Needs a Separate Taxpaying Entity
A REIT exists under a bargain with the tax code: distribute at least 90% of taxable income to shareholders and pay no corporate tax on what gets distributed, but stay inside tight limits on what the entity does and how it earns money.2U.S. Securities and Exchange Commission. Investor Bulletin: Real Estate Investment Trusts Three of those limits push activity into a TRS.
The 75% and 95% Gross Income Tests
A REIT must draw at least 75% of its gross income from core real estate sources: rents from real property, mortgage interest, gains from selling real estate that isn’t dealer property, and dividends from other REITs. A broader test requires that at least 95% come from those sources plus dividends, interest, and gains from securities of any kind.3Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust Income from running an operating business, charging for non-customary tenant services, or flipping properties fits neither test. Without a separate entity to absorb that income, the REIT would fail to qualify.
Impermissible Tenant Service Income
REITs can provide basic building services like common-area maintenance or trash removal without a problem. Trouble starts with non-customary services such as a concierge desk, a fitness center, or specialized janitorial work beyond what a typical building offers. If a REIT earns income from these services and the amount exceeds 1% of all income from that property for the year, the entire service income for that property gets reclassified as impermissible tenant service income and stops counting as qualifying rent.4Legal Information Institute. 26 U.S. Code 856 – Impermissible Tenant Service Income
When a TRS furnishes services to the REIT’s tenants, those services are treated as if the REIT never provided them, so the rent stays clean.5Internal Revenue Service. Revenue Ruling 2002-38 The TRS collects the service revenue on its own return, pays corporate tax on the profit, and the parent REIT’s rental income remains fully qualifying.
The Prohibited Transaction Tax
A REIT that sells property held primarily for sale to customers in the ordinary course of business, essentially acting as a developer or flipper, owes a 100% tax on the net income from that sale. That is not a typo. The IRS takes the entire profit. Safe harbors exist (the REIT held the property at least two years, capital improvements stayed below 30% of the selling price, and the REIT made no more than seven sales during the tax year, among other conditions), but they are narrow and easy to miss.6Office of the Law Revision Counsel. 26 U.S. Code 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
A TRS sidesteps the problem. It can buy land, build on it, and sell the finished product as a dealer, paying the regular 21% corporate tax on the gain instead of the REIT’s punitive 100% tax. For any REIT with a development pipeline, that arithmetic makes the TRS indispensable.
What a TRS Typically Does
TRS entities show up wherever a REIT’s business touches something more active than collecting rent.
- Hotel and lodging operations. A REIT can own a hotel, but the TRS typically leases it from the REIT and hires an eligible independent contractor to manage daily operations. The TRS itself cannot directly operate or manage a lodging or health care facility. This three-party structure (REIT as owner, TRS as lessee, independent operator as manager) is how most hotel REITs are organized.7Office of the Law Revision Counsel. 26 U.S. Code 856 – Definition of Real Estate Investment Trust
- Health care facilities. The same eligible-independent-contractor requirement applies: the REIT owns the building, the TRS leases it, and a third-party operator runs it.
- Non-customary tenant services. Anything beyond basic building maintenance that tenants want, from package delivery to specialized security to conference-room booking, can generate revenue through the TRS without contaminating the REIT’s rental income.
- Property development and sales. When the strategy involves building and selling rather than holding long-term, the TRS handles the dealer activity.
- Third-party property management. If the REIT’s management team also manages buildings the REIT doesn’t own, those management fees are non-qualifying income. A TRS collects them instead.
How a TRS Gets Created
Setting one up is straightforward on paper. The REIT and a corporation it owns stock in file IRS Form 8875, making a joint election to treat that corporation as a taxable REIT subsidiary.8Internal Revenue Service. IRS Form 8875 – Taxable REIT Subsidiary Election The REIT must directly or indirectly own stock in the corporation, but nothing prevents third parties from also holding shares. Once made, the election is irrevocable unless both parties agree to revoke it, and neither the election nor any revocation requires IRS permission.7Office of the Law Revision Counsel. 26 U.S. Code 856 – Definition of Real Estate Investment Trust
One detail catches people off guard. If an existing TRS of a REIT owns more than 35% of the voting power or total value of another corporation’s securities, that second corporation automatically becomes a TRS of the same REIT, no election needed. The rule prevents a REIT from burying non-qualifying activities in a chain of subsidiaries that technically never elected TRS status.
The 20% Asset Cap
A REIT cannot park unlimited value in its TRS entities. The securities of all TRSs combined cannot exceed 20% of the total value of the REIT’s assets, measured at fair market value.9Internal Revenue Service. Taxable REIT Subsidiaries Analysis of the First Year’s Returns Tax Year 2001 This cap is the main structural restraint ensuring that a REIT remains primarily a passive real estate owner rather than an operating company with a REIT wrapper.
Monitoring the limit is harder than it sounds. As real estate values move, the denominator shifts, and so does the 20% threshold. A booming TRS business or a dip in property values can push the ratio past the cap without any new investment. REITs typically track this quarterly, because the asset tests are measured at the close of each calendar quarter.
If a REIT breaches the limit, it can still preserve REIT status when the failure was due to reasonable cause and not willful neglect. The REIT must identify the problem, describe the offending assets in a schedule filed with the IRS, and dispose of the excess assets within six months. Even with the cure, the REIT owes a tax equal to the greater of $50,000 or an amount tied to the net income from the non-compliant assets. A separate de minimis exception covers failures where the excess assets are worth less than the lesser of 1% of total REIT assets or $10 million.
Arm’s-Length Pricing and the 100% Excise Tax
The IRS anticipated that REITs and TRS entities would be tempted to manipulate intercompany pricing, shifting income into the tax-advantaged REIT or loading deductions onto the TRS. The response was a 100% excise tax on four categories of abuse: redetermined rents, redetermined deductions, excess interest, and redetermined TRS service income.10Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
The common scenario works like this. A REIT owns a building and leases it to its TRS, which operates a hotel. If the IRS determines that the rent would need to be adjusted downward under transfer-pricing rules to reflect the economic reality of the TRS providing services to the REIT’s tenants, the difference between the actual rent and the arm’s-length rent is redetermined rent. The REIT owes 100% of that amount as excise tax, on top of whatever regular tax was already due. The same logic applies if the TRS overpays interest on loans from the REIT or if the REIT shifts deductions to the TRS.
The statute carves out several exceptions for TRS service income that keep the 100% tax from triggering in legitimate arrangements:
- De minimis amounts. If the service income from a property falls within the 1% impermissible-tenant-service-income threshold, the 100% tax doesn’t apply.
- Comparably priced services. If the TRS charges unrelated third parties similar fees for similar services, and the charges to REIT tenants are substantially comparable, the excise tax doesn’t kick in.
- Separately stated charges. If the service is billed separately from rent, and tenants who don’t use the service pay substantially comparable rent to those who do, the arrangement passes muster.
- 150% of direct cost. If the TRS’s gross income from the service equals at least 150% of its direct cost to provide it, the excise tax doesn’t apply.
These exceptions give REITs real room to operate, but the documentation burden is heavy. The REIT needs transfer-pricing studies, comparable-fee analyses, or cost-plus calculations ready for each intercompany arrangement. Getting this wrong doesn’t just mean paying the normal tax that should have been paid. It means paying that tax plus a 100% penalty on top.
How TRS Income Reaches the REIT and Its Shareholders
The TRS files its own corporate return and pays the 21% federal corporate income tax on its net income, plus any applicable state corporate taxes. State rates run roughly from 2% to nearly 12% depending on where the TRS operates, so the combined tax bite can approach a third of the TRS’s profits before any money reaches the parent REIT.
After paying its own taxes, the TRS distributes remaining earnings to the REIT as dividends. Those dividends then interact with the REIT’s income tests in an asymmetric way. Dividends from the TRS count as qualifying income for the broader 95% test, because that test includes dividends from any source. They do not qualify under the stricter 75% test, which is limited to real estate rents, mortgage interest, real estate sale gains, and dividends from other REITs.
That asymmetry creates a natural speed limit. Every dollar of TRS dividends the REIT receives dilutes the percentage of income that qualifies for the 75% test. If the REIT’s real estate income doesn’t comfortably clear 75% on its own, growing the TRS’s distributions becomes risky. Combined with the 20% asset cap, this effectively limits how large a role the TRS can play in the overall enterprise.
The double taxation is real. The TRS earns income and pays corporate tax. The after-tax profit goes to the REIT as a dividend. The REIT distributes at least 90% of its taxable income (including that TRS dividend) to shareholders, who pay tax again at their individual rates. Income flowing through the TRS gets taxed twice before it reaches investors, compared with once for income the REIT earns directly from rent. That cost is worth bearing only when the alternative, losing REIT status or paying the 100% prohibited transaction tax, is worse.
What Happens If the Rules Are Broken
The consequences depend on which rule is violated. A REIT that fails the 75% or 95% gross income threshold doesn’t automatically lose REIT status if the failure was due to reasonable cause, but it owes a penalty tax based on the amount of non-qualifying income that caused the failure.
For the asset tests, the cure mechanism gives the REIT six months to fix a breach of the 20% TRS cap, but the minimum $50,000 penalty still applies even for good-faith mistakes. If the failure isn’t cured in time or wasn’t due to reasonable cause, the entity loses its REIT election entirely and cannot re-elect for five years. Losing REIT status means the entire entity pays corporate tax on all its income, a catastrophic outcome for shareholders who invested expecting pass-through treatment.
The 100% excise tax on redetermined items operates independently. It doesn’t threaten REIT status, but it can wipe out the economic benefit of the TRS arrangement in a single audit. A REIT that charges below-market rent to its TRS and gets caught doesn’t just owe the tax it should have collected. It owes the full redetermined amount as a penalty, which makes non-compliance far more expensive than pricing the transaction correctly from the start.