Is a REIT a Corporation? Structure and Tax Differences

Real Estate Investment Trusts (REITs) share structural and operational similarities with traditional corporations, but they possess fundamental differences, particularly in their tax treatment and specific requirements. This article explores their commonalities and divergences.

Understanding Corporate Structure

A traditional corporation is a legal entity distinct from its owners, known as shareholders. This separation provides limited liability, protecting shareholders’ personal assets from the corporation’s debts and legal obligations. Corporations are designed for perpetual existence, continuing even if ownership changes.

A significant characteristic of corporations is their tax structure, commonly known as double taxation. The corporation first pays income tax on its profits at the corporate level. After the corporation pays its taxes, any remaining profits distributed to shareholders as dividends are then taxed again at the individual shareholder level.

Understanding the REIT Structure

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Congress established REITs in 1960 to make large-scale real estate investments accessible to individual investors.

To qualify as a REIT and receive favorable tax treatment, a company must meet specific requirements outlined in the Internal Revenue Code. These requirements include asset tests, which mandate that at least 75% of a REIT’s total assets must be real estate assets, cash, or U.S. government securities. Income tests specify that at least 75% of a REIT’s gross income must come from real estate-related sources, such as rents from real property or interest on mortgages secured by real property. Furthermore, at least 95% of its gross income must be from real property-related sources, dividends, interest, or securities.

A crucial requirement for REIT status is the distribution requirement, which mandates that a REIT must distribute at least 90% of its taxable income to shareholders as dividends. By meeting these stringent criteria, REITs gain their special tax status, which largely avoids corporate-level income tax.

Commonalities Between REITs and Corporations

Many REITs are structured legally as corporations under state law. Like traditional corporations, REITs offer limited liability to their shareholders, protecting investors’ personal assets from the company’s liabilities. This provides a similar level of financial protection to individuals investing in corporate stocks.

A significant number of REITs are publicly traded on major stock exchanges, providing investors with liquidity. The management of a REIT is also overseen by a board of directors or trustees, similar to the governance structure of a standard corporation. These shared characteristics, such as transferable shares and regulated governance, make REITs appear, on the surface, to function much like other publicly traded companies.

Fundamental Differences

The primary distinction between a REIT and a traditional corporation lies in their tax treatment. A conventional corporation is subject to federal income tax on its profits, and then shareholders are taxed again on dividends received, a system known as double taxation. This means the same earnings are taxed twice, once at the entity level and again at the individual investor level.

This is primarily due to the “dividends paid deduction,” which allows REITs to deduct the income distributed to shareholders from their taxable income. As a result, income generated by a REIT is taxed primarily at the shareholder level, effectively creating a single layer of taxation. This pass-through taxation model is a core advantage of the REIT structure, designed to encourage investment in real estate by reducing the tax burden that would otherwise apply to traditional corporations.

Another significant operational difference is the mandatory distribution requirement for REITs. To maintain their tax-advantaged status, REITs must distribute at least 90% of their taxable income to shareholders annually. This contrasts sharply with the discretionary dividend policies of most corporations, which can choose to retain a larger portion of their earnings for reinvestment, debt reduction, or other corporate purposes. While corporations decide how much profit to distribute as dividends, REITs are compelled to pay out a substantial portion, which impacts their ability to retain earnings for internal growth.

Investor Considerations

The unique structure and tax treatment of REITs have direct implications for investors. Most REIT dividends are taxed as ordinary income at the investor’s marginal tax rate, rather than at the lower qualified dividend rates often applicable to dividends from traditional corporations. This is because REIT dividends are typically considered distributions of the REIT’s operating profit, which has not been taxed at the corporate level. While some REIT dividends may qualify for a 20% deduction under Section 199A of the Tax Cuts and Jobs Act through the end of 2025, the majority are still subject to ordinary income tax rates.

The public trading of many REITs provides investors with liquidity, allowing them to buy or sell shares relatively easily on stock exchanges. This accessibility is similar to investing in corporate stocks, offering a way to gain exposure to the real estate market without direct property ownership. However, investors should recognize that the underlying asset class, real estate, and the specific tax structure of REITs differentiate them from typical corporate investments. Understanding how REIT distributions are taxed at the individual level is crucial for effective financial planning, as it directly impacts the net return on investment.