Are REITs Pass-Through Entities for Tax Purposes?

A Real Estate Investment Trust (REIT) provides a means for individuals to invest in large-scale, income-producing real estate without directly purchasing or managing properties. REITs typically own and operate a diverse portfolio of real estate assets, ranging from apartment complexes and shopping centers to data centers and healthcare facilities. The unique tax structure of REITs is designed to allow for certain benefits, which influences how income is ultimately treated for investors.

Understanding Pass-Through Entities

A pass-through entity is a business structure where income, gains, losses, and deductions are “passed through” directly to the owners or investors for tax purposes, rather than being taxed at the entity level. This design helps avoid the issue of double taxation, where corporate profits are taxed once at the company level and again when distributed to shareholders as dividends. Instead, the profits from a pass-through entity are reported on the individual tax returns of its owners, who then pay taxes at their personal income tax rates. Common examples of pass-through entities include sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations.

Real Estate Investment Trusts are specifically designed as pass-through entities under U.S. tax law, primarily governed by Internal Revenue Code (IRC) Subchapter M. This classification permits REITs to deduct dividends paid to shareholders from their taxable income, effectively reducing or eliminating corporate-level tax. The ability to avoid corporate income tax is a primary reason for the existence and popularity of the REIT structure.

REIT Qualification Requirements

To maintain their pass-through taxation status, REITs must adhere to a strict set of qualification requirements outlined in Internal Revenue Code Section 856. One significant criterion involves the composition of a REIT’s assets. At least 75% of a REIT’s total assets must consist of real estate assets, cash, and government securities. Additionally, a REIT cannot hold more than 5% of its total assets in the securities of any one issuer, nor can it own more than 10% of the voting securities of any single issuer. These asset tests are evaluated at the end of each calendar quarter.

REITs also face income tests to ensure their earnings are primarily derived from real estate activities. The first, known as the 75% gross income test, mandates that at least 75% of a REIT’s gross income must come from real estate-related sources, such as rents from real property, interest on mortgages, and gains from the sale of real estate. A second income test, the 95% gross income test, requires that at least 95% of the REIT’s gross income be derived from these real estate sources, along with other passive income like dividends and interest from any source. Failure to meet these income tests can result in penalties or even the loss of REIT status, leading to taxation as a regular corporation.

A key requirement for a REIT’s pass-through nature is its distribution obligation. To qualify as a REIT, the entity must distribute at least 90% of its taxable income to its shareholders annually. This high distribution threshold ensures that most of the REIT’s income is passed through to investors, thereby avoiding taxation at the corporate level. While cash distributions are common, REITs may satisfy this requirement through a combination of cash and stock distributions.

Beyond financial metrics, REITs must satisfy certain organizational and ownership requirements. A REIT must be managed by one or more trustees or directors and its beneficial ownership must be evidenced by transferable shares. For its second taxable year and beyond, a REIT must have at least 100 shareholders for a specified period. Furthermore, a REIT cannot be “closely held,” meaning that five or fewer individuals cannot own more than 50% of the value of its outstanding stock during the last half of the taxable year. These ownership rules are designed to ensure broad public ownership and prevent the entity from functioning as a personal holding company.

Taxation of REIT Dividends

The dividends distributed by REITs are subject to specific tax treatments at the individual investor level, largely due to their pass-through structure. Most REIT dividends are taxed as ordinary income, similar to wages, rather than as qualified dividends. The maximum ordinary income tax rate can be as high as 37%. Investors receive information on the tax character of their REIT distributions on Form 1099-DIV.

A tax benefit for some investors receiving REIT dividends is the potential eligibility for the Qualified Business Income (QBI) deduction. Under a provision of the Internal Revenue Code, eligible taxpayers may deduct up to 20% of their qualified REIT dividends. This deduction can effectively reduce the tax rate on ordinary REIT dividends for those who qualify.

Beyond ordinary income, REIT distributions can also include capital gain dividends and return of capital distributions, each with distinct tax implications. Capital gain dividends occur when the REIT distributes gains realized from the sale of properties. These are taxed as long-term capital gains, regardless of how long the investor has held the REIT shares. The maximum long-term capital gains tax rate can be up to 20%, plus a potential 3.8% net investment income tax.

Return of capital distributions represent a portion of the investor’s original investment being returned, rather than income or gains. These distributions are not immediately taxable; instead, they reduce the investor’s cost basis in the REIT shares. Taxation is deferred until the shares are sold, at which point a lower cost basis could result in a larger taxable capital gain. This defers tax liability for long-term investors.

The tax treatment of REIT dividends also depends on the type of account in which they are held. When REITs are held in tax-advantaged retirement accounts, such as Individual Retirement Accounts (IRAs) or 401(k)s, the dividends are not taxed until withdrawal, or they may be entirely tax-exempt if held in a Roth account. In contrast, REITs held in taxable brokerage accounts are subject to the immediate tax implications of ordinary income, capital gains, or return of capital distributions as they occur.