How to Form a Private Real Estate Investment Trust

A Private Real Estate Investment Trust (REIT) is an investment vehicle allowing individuals to participate in large-scale real estate ventures. It consolidates capital from a select group of investors, deploying it to acquire and manage income-generating real estate properties. These properties can include apartment complexes, commercial buildings, industrial warehouses, and mortgages.

Private REITs avoid corporate-level taxation, provided they distribute most earnings to shareholders. This pass-through taxation means income is generally taxed only at the shareholder level, offering a tax-efficient way to invest in real estate. Investors gain exposure to institutional-quality real estate without directly owning or managing the properties.

Qualifying for REIT Status

Becoming a Real Estate Investment Trust requires adherence to specific Internal Revenue Service (IRS) criteria. These requirements are categorized into organizational, asset, income, and distribution tests that must be met consistently.

Organizational tests establish the entity’s fundamental structure. A REIT must be managed by trustees or directors, and its shares must be transferable. The entity must be taxable as a domestic corporation, electing REIT status. After its first tax year, a REIT is required to have 100 or more persons owning its shares.

Asset tests ensure the REIT’s investments are primarily in real estate. Quarterly, at least 75% of the REIT’s total assets must consist of real estate assets, cash, and government securities. This includes real property, interests in real property, and mortgages on real property. No more than 25% of the REIT’s assets can be other securities.

Within the 25% asset test, limitations prevent over-concentration. The value of securities held in any one issuer cannot exceed 5% of the REIT’s total assets. A REIT cannot own more than 10% of the outstanding voting securities or 10% of the total value of outstanding securities of any one issuer.

Income tests dictate the sources of annual gross income. At least 75% of the REIT’s gross income must come from real estate-related sources. This includes rents from real property, interest on mortgages secured by real property, and gains from real property sales.

At least 95% of the REIT’s gross income must be derived from these real estate sources or other passive income sources. These additional passive income sources include dividends, interest, and gains from the sale of stock or securities.

The distribution test ensures most income flows to shareholders. A REIT must distribute at least 90% of its taxable income to its shareholders annually.

Forming the Private REIT Entity

Establishing a private REIT involves legal and administrative steps to create the entity and elect its tax status. The initial decision is selecting the appropriate legal structure. Most private REITs are formed as corporations for federal income tax purposes, even if organized as a business trust under state law.

Once the entity type is chosen, drafting organizational documents is a priority. For a corporation, this involves preparing Articles of Incorporation, filed with the relevant state authority, such as the Secretary of State. These articles outline the corporation’s basic structure, including its name, purpose, and authorized shares. A Declaration of Trust serves a similar purpose for a business trust.

These foundational documents must include specific provisions to ensure compliance with REIT organizational tests. They should state that the entity will be managed by a board of directors or trustees. Provisions related to the transferability of shares are also essential to meet REIT qualification requirements.

After preparing the organizational documents, the entity must formally register with the appropriate state authority. This typically involves submitting the Articles of Incorporation or Declaration of Trust to the Secretary of State in the state of formation. This registration establishes the entity as a legal operating business.

Following state registration, the newly formed entity must obtain an Employer Identification Number (EIN) from the IRS. The EIN is a unique nine-digit number assigned to business entities for tax purposes. It is required for various activities, including opening bank accounts and filing federal tax returns. An EIN can be obtained online through the IRS website.

The final step in forming the private REIT entity is electing to be treated as a REIT for federal income tax purposes. This is accomplished by filing Form 1120-REIT, U.S. Income Tax Return for Real Estate Investment Trusts. This form serves as the formal election and is filed for the first tax year the entity wishes to qualify as a REIT. The election must be made with the entity’s first tax return for the year it desires REIT status, and it must satisfy all qualification requirements by that time.

Raising Capital for Your Private REIT

Securing investment capital for a private REIT involves navigating specific regulations for private offerings, which differ significantly from public solicitations. Private REITs rely on exemptions from SEC registration requirements under the Securities Act of 1933, primarily through Regulation D.

Two prominent rules under Regulation D are Rule 506(b) and Rule 506(c), each with distinct parameters for soliciting and verifying investors. Rule 506(b) offerings do not permit general solicitation or advertising. Under this rule, a private REIT can accept an unlimited number of accredited investors and up to 35 non-accredited investors, provided non-accredited investors receive specific financial information.

In contrast, Rule 506(c) allows for general solicitation and advertising. However, all investors in a Rule 506(c) offering must be accredited investors. The issuer must also take reasonable steps to verify the accredited status of each investor, often involving reviewing financial documents or obtaining third-party verification.

An accredited investor, for individuals, means having a net worth exceeding $1 million, alone or with a spouse, excluding their primary residence. Alternatively, an individual can qualify with an income exceeding $200,000 in each of the two most recent years, or $300,000 with a spouse, with a reasonable expectation of reaching the same income level in the current year. For entities, the definition includes organizations with assets exceeding $5 million, such as trusts, corporations, partnerships, or certain investment funds.

Regardless of the specific Rule 506 exemption, a private REIT undertaking a capital raise prepares essential offering documents. The Private Placement Memorandum (PPM) or Offering Circular is the primary disclosure document provided to prospective investors. This document outlines the offering, risk factors, and intended use of the capital raised.

The PPM also includes financial projections for the REIT, information about the management team’s experience, and a summary of the organizational structure. This document informs potential investors about the investment and helps them make an informed decision.

Following the first sale of securities in a Regulation D offering, the private REIT must file Form D with the SEC. This brief notice filing provides the SEC with basic information about the offering, such as the issuer’s identity, executive officers, directors, amount of securities offered, and the exemption claimed. Form D must be filed within 15 days after the first sale of securities.

Maintaining REIT Compliance

Sustaining a private REIT’s tax-advantaged status requires continuous oversight and adherence to IRS qualification tests. Asset and income tests, initially met during qualification, must be monitored ongoing. Asset tests are applied quarterly, necessitating regular reviews of the REIT’s balance sheet to ensure the 75% and 25% thresholds are maintained.

Income tests, requiring at least 75% and 95% of gross income from specified sources, are evaluated annually. The REIT’s management must track all revenue streams to confirm compliance. Failure to meet these ongoing tests can result in the loss of REIT status, leading to corporate-level taxation and financial penalties.

The distribution requirement mandates payout of at least 90% of taxable income to shareholders. This distribution must occur within the tax year or by the end of January of the following year. If a REIT discovers a shortfall, it may use a “deficiency dividend” procedure to cure the failure, though this involves additional steps and potential interest payments to the IRS.

Record-keeping is important for demonstrating compliance with all REIT tests and regulatory obligations. This includes maintaining records of assets acquired and disposed of, documenting income sources, and tracking shareholder ownership and distributions. Internal controls and accounting systems support these efforts and facilitate timely reporting.

Annual tax filings are a significant part of ongoing compliance, primarily through Form 1120-REIT. This form reports the REIT’s income, deductions, and distributions for the year, confirming its continued qualification. Accurate and timely filing avoids penalties and maintains the REIT’s tax-exempt status at the corporate level.

A private REIT also has obligations to its shareholders regarding tax reporting. It must provide shareholders with information about distributions received, typically through Form 1099-DIV. This form details the type of income distributed, such as ordinary dividends, qualified dividends, or return of capital, which shareholders need for their personal income tax returns.

Effective operational management of the real estate portfolio directly supports the REIT’s ability to meet ongoing compliance. Consistent income generation through efficient property management, strategic leasing, and asset maintenance contributes to meeting income and distribution tests. Management of underlying real estate assets is key to the REIT’s sustained financial health and its ability to maintain its tax-advantaged status.