Can REITs Invest in Limited Partnerships?

Real Estate Investment Trusts (REITs) provide investors access to income-generating real estate with favorable tax treatment. However, they must follow strict regulations regarding asset composition and income distribution. This raises questions about whether REITs can invest in limited partnerships (LPs), which have different ownership structures and tax implications.

Understanding how REITs interact with LP investments requires examining regulatory requirements, ownership considerations, tax treatment, and compliance obligations.

Regulatory Requirements for REIT Investing

To qualify as a REIT under the Internal Revenue Code (IRC), an entity must meet specific asset and income criteria. The 75% asset test requires at least 75% of a REIT’s total assets to consist of real estate, cash, and government securities. The 75% income test mandates that at least 75% of a REIT’s gross income come from real estate-related sources such as rental income, mortgage interest, and property sales. These limits restrict REITs from investing heavily in entities that do not primarily hold real estate assets.

The 25% asset test further limits a REIT’s ability to invest in non-qualifying assets, including partnerships that do not meet the real estate asset threshold. If an LP investment results in ownership of assets that do not qualify under the 75% test, the REIT risks losing its status and becoming subject to corporate income tax.

REITs must also comply with the 5/50 rule, which ensures that no more than 50% of a REIT’s shares are held by five or fewer individuals in the last half of the taxable year. If a REIT invests in an LP, it must ensure the partnership structure does not violate this rule, especially if the LP has a small number of controlling partners.

Ownership Structures in Limited Partnerships

Limited partnerships consist of at least one general partner (GP) who manages operations and assumes unlimited liability, while limited partners (LPs) contribute capital with liability restricted to their investment. REITs typically invest as limited partners to avoid operational risks and maintain their passive income focus.

A REIT’s involvement in an LP is governed by the partnership agreement, which dictates voting rights, profit distribution, and exit mechanisms. Some LPs grant limited partners protective rights, such as approving major asset sales or business strategy changes. If a REIT’s role is deemed too active, it could raise concerns about its classification as a passive income-generating entity under REIT regulations.

One way REITs invest in LPs is through an umbrella partnership real estate investment trust (UPREIT). In this structure, the REIT holds interests in an operating partnership (OP), which owns real estate assets. Property owners can contribute assets in exchange for OP units rather than direct REIT shares, deferring capital gains taxes. The UPREIT model provides liquidity and diversification while maintaining compliance with REIT asset and income tests.

Tax Treatment of Partnership Interests

When a REIT acquires an interest in an LP, tax implications depend on how income, deductions, and liabilities are allocated. LPs are pass-through entities, meaning income and losses flow directly to partners without entity-level taxation. However, a REIT must ensure that the partnership’s income retains its character when passed through, as only certain types of income qualify under REIT tax rules. Rental income from real property generally qualifies, while active business income could create compliance issues.

The allocation of taxable income within an LP is governed by IRC Section 704, which allows partnerships to structure income and loss allocations through the partnership agreement. A REIT receiving a disproportionate share of non-qualifying income—such as income from services or short-term property sales—could jeopardize its ability to meet the 75% and 95% gross income tests required under IRC Sections 856(c)(2) and 856(c)(3). If the LP generates unrelated business taxable income (UBTI), the REIT may face unexpected tax liabilities.

Depreciation deductions within an LP also impact tax planning. While REITs benefit from depreciation on directly owned properties, they must evaluate how depreciation is allocated within the partnership. If an LP disproportionately allocates depreciation to other partners, the REIT could report more taxable income than expected, increasing its distribution obligations. Conversely, if the REIT receives a large depreciation allocation, it could reduce taxable income, but this may also lower required distributions, affecting investor expectations.

Distribution Requirements

REITs must distribute at least 90% of their taxable income to shareholders annually to maintain their tax-advantaged status. When a REIT holds an interest in an LP, the timing and nature of distributions become more complex due to the LP’s cash flow management and distribution policies.

LP agreements dictate how earnings are allocated and distributed among partners, but these rules may not align with a REIT’s minimum distribution threshold. Unlike dividends from traditional equity investments, partnership distributions are based on available cash rather than taxable income. This means a REIT could recognize taxable income from an LP investment without receiving a corresponding cash distribution. This creates a liquidity challenge, as the REIT must still meet its payout obligations to shareholders, potentially forcing asset sales or debt financing to cover shortfalls.

Compliance and Reporting

Investing in an LP introduces additional compliance and reporting obligations for a REIT. Since REITs must adhere to strict regulatory requirements, they must ensure that any LP investment does not create reporting inconsistencies or trigger penalties.

REITs holding LP interests must carefully report partnership income on their tax filings, typically using Schedule K-1 issued by the LP. This document details the REIT’s share of income, deductions, and credits, which must be incorporated into financial statements and tax returns. Any misalignment between reported income and actual cash distributions could affect the REIT’s ability to meet its 90% distribution requirement. Additionally, if the LP generates income from activities that do not qualify under REIT income tests, the REIT must segregate and disclose these amounts to ensure compliance with IRS regulations. Failure to properly account for non-qualifying income could result in excise taxes or loss of REIT status.