Are REITs Tax Exempt? How REITs Are Actually Taxed

While Real estate investment trusts (REITs) enjoy a special tax status, they are not tax-exempt. This distinct tax advantage primarily applies at the corporate level, provided specific conditions are met. The income generated by REITs is ultimately taxed, but this burden shifts from the entity to its shareholders.

How REITs are Taxed at the Corporate Level

REITs operate under a unique tax structure that generally allows them to avoid corporate income tax, distinguishing them from typical corporations. This favorable treatment is contingent upon the REIT distributing a substantial portion of its taxable income to its shareholders. REITs can deduct the dividends they pay to shareholders from their corporate taxable income, effectively turning them into “pass-through” entities for tax purposes.

To maintain this status and avoid corporate taxation, a REIT must distribute at least 90% of its taxable income to shareholders annually, as outlined in IRC Section 857. Meeting this distribution threshold shifts the tax burden directly to individual shareholders.

Any income a REIT retains and does not distribute remains subject to corporate income tax. While the 90% rule is the minimum for maintaining their special status, many REITs aim to distribute 100% to completely avoid corporate tax. This structure encourages consistent earnings distribution to investors.

How REIT Distributions are Taxed for Investors

Investors in REITs receive income through distributions, which are categorized and taxed differently. Your tax liability depends on how each portion of your REIT distribution is classified, as detailed on IRS Form 1099-DIV.

Ordinary dividends are the most common REIT distribution, taxed at the investor’s ordinary income tax rate. Unlike many corporate dividends, REIT ordinary dividends do not qualify for lower “qualified dividend” tax rates (IRC Section 857). However, a portion may be eligible for a 20% qualified business income (QBI) deduction under IRC Section 199A, reported in Box 5 of Form 1099-DIV, which can reduce the effective tax rate.

Capital gain dividends arise from the REIT’s sale of underlying properties. These distributions are taxed at the investor’s long-term capital gains rates. Form 1099-DIV reports these amounts.

A third type of distribution is the return of capital. These are non-taxable at receipt, considered a return of your initial investment. They reduce your cost basis in the REIT shares, with taxation occurring when you eventually sell your shares.

Investors can manage the immediate tax impact of REIT distributions by holding them within tax-advantaged accounts, such as Individual Retirement Accounts (IRAs) or 401(k)s. Income and capital gains within these accounts are tax-deferred until withdrawal. This contrasts with holding REITs in a taxable brokerage account, where distributions are subject to current taxation.

Key Requirements for Maintaining REIT Status

Maintaining REIT status involves adhering to a strict set of requirements outlined in the Internal Revenue Code, ensuring the entity primarily operates as a real estate investment vehicle. Failure to meet these conditions can result in the loss of special tax treatment, subjecting the REIT to corporate income tax like a standard corporation. These rules ensure REITs function as intended, distributing most of their income to shareholders.

Asset tests mandate how a REIT’s assets must be composed. At least 75% of its total assets must be invested in real estate assets, cash, cash equivalents, and government securities. This test is applied quarterly and ensures the REIT’s portfolio is predominantly real estate-focused.

Income tests impose specific requirements on a REIT’s revenue sources. At least 75% of its gross income must be derived from real estate-related sources, such as rents from real property, interest on mortgages, or gains from the sale of real estate. Additionally, at least 95% of its gross income must come from these real estate sources or from dividends and interest from any source, including the sale of securities. These income tests prevent REITs from engaging in substantial non-real estate business activities.

The distribution requirement mandates that a REIT must distribute at least 90% of its taxable income to shareholders each year. This allows the REIT to deduct the distributed income, thereby avoiding corporate-level taxation. If a REIT falls short of this 90% distribution, it risks losing its favorable tax status or incurring excise taxes.

Organizational and ownership tests further define a REIT’s structure. A REIT must be managed by a board of directors or trustees, and its shares must be transferable. There is also a “100 shareholder test,” requiring the REIT to have at least 100 shareholders after its first tax year. Furthermore, a REIT cannot be “closely held,” meaning that five or fewer individuals cannot own more than 50% of its outstanding stock during the last half of the taxable year. These ownership rules promote broad public ownership and prevent the entity from being a personal investment vehicle for a small group.