REIT Income Test Requirements: The 75% and 95% Rules

A Real Estate Investment Trust, or REIT, is a company that owns and operates income-producing real estate. REITs allow individuals to invest in large-scale, income-producing real estate portfolios through the purchase of stock. By meeting specific requirements in the Internal Revenue Code, a REIT can act as a pass-through entity, deducting dividends paid to shareholders from its corporate taxable income. This structure avoids the double taxation that is typical for standard corporations.

To maintain this advantageous tax status, a REIT must comply with a series of organizational and operational rules. Among these ongoing requirements are two gross income tests, which are designed to ensure the entity’s income is primarily derived from passive real estate activities. Adherence to these annual income tests is a core component of maintaining REIT status and its associated tax benefits.

The 75% Gross Income Test

The 75% gross income test, as detailed in Internal Revenue Code Section 856, mandates that for each taxable year, at least 75% of a REIT’s gross income must originate from a narrow list of real estate-related sources. The test is designed to ensure that a REIT’s financial activities are fundamentally tied to real property, reinforcing its purpose as a real estate investment vehicle. Failure to meet this test can jeopardize the entity’s REIT status for the year.

A primary source of qualifying income is “rents from real property.” This category includes charges for services customarily provided in connection with renting real estate, such as utilities and general maintenance. However, income derived from non-customary services, such as housekeeping, or rental income based on a tenant’s net income is excluded.

Beyond rents, several other income streams satisfy the 75% test. Interest on obligations secured by mortgages on real property is a significant source, which allows mortgage REITs to meet the requirement. Gains from the sale or other disposition of real property also qualify, provided the property is not held primarily for sale to customers in the ordinary course of business.

Other qualifying sources include dividends received from other REITs, which encourages investment within the REIT sector. Income and gain derived from “foreclosure property”—a status a REIT can elect for a property it acquires through foreclosure—is also considered qualifying income. This provision gives the REIT a grace period to reposition or sell the property without the income tainting its compliance.

The 95% Gross Income Test

In addition to the 75% test, a REIT must also satisfy a broader 95% gross income test annually. This second requirement stipulates that at least 95% of a REIT’s gross income must come from the same sources that qualify for the 75% test, plus a selection of other passive income types. This test effectively limits the amount of non-passive, or “bad,” income a REIT can earn to a maximum of 5% of its total gross income for the year.

The additional categories of income that are permitted do not need a direct link to real estate. These sources include dividends from non-REIT corporations, interest from non-mortgage sources like bonds or bank accounts, and gains from the sale or disposition of stocks and securities.

The inclusion of these other passive income sources provides a REIT with greater flexibility in managing its cash reserves and short-term investments. For instance, a REIT can invest in a portfolio of publicly traded stocks or corporate bonds and the resulting dividends, interest, and capital gains will count toward satisfying the 95% test. This allows the entity to generate returns on its working capital without violating its operational mandates.

Managing Non-Qualifying Income Sources

The small 5% sliver of gross income that falls outside the 95% test provides a REIT with a minimal capacity to absorb non-qualifying income, often referred to as “bad income.” This could include revenue from services deemed non-customary for a landlord. A more structured and common approach to handling non-qualifying activities is through the use of a Taxable REIT Subsidiary (TRS).

A TRS is a separate corporation that a REIT can own to conduct activities and generate income that would otherwise be impermissible for the REIT itself. Because the TRS is a distinct, fully taxable C corporation, its income is not subject to the REIT income tests. The REIT’s income from the TRS, typically in the form of dividends, is considered qualifying income for the 95% test (but not the 75% test), allowing the REIT to profit from these ventures without jeopardizing its tax status.

For example, a REIT that owns a portfolio of hotels cannot directly operate them, as the income from providing lodging and extensive guest services is non-qualifying. Instead, the REIT can lease the hotels to its TRS, which then operates them. The REIT receives qualifying rental income from the TRS, while the non-qualifying operational income is contained within the taxable subsidiary.

Consequences of Failing an Income Test

Failing to meet either the 75% or 95% income test for a taxable year carries significant consequences, the most severe of which is the potential termination of the company’s REIT status. If an entity loses its REIT election, it is treated as a standard C corporation for tax purposes. This means its profits would be subject to corporate income tax before any distributions are made to shareholders, eliminating the primary tax advantage of the REIT structure.

However, an accidental failure of an income test does not automatically lead to disqualification. The Internal Revenue Code provides relief provisions for REITs that fail one or both tests, provided the failure is due to reasonable cause and not willful neglect.

To qualify for this relief, the REIT must meet several conditions. First, it must identify the failure. Following the identification, the REIT must attach a schedule to its income tax return that describes each item of its gross income in detail.

The most direct consequence of using this relief provision is a penalty tax. The REIT must pay a tax, calculated under Internal Revenue Code Section 857, on the excess non-qualifying income. This penalty effectively claws back the tax benefit associated with the income that caused the failure, ensuring that while a REIT can be saved from disqualification, it cannot profit from its compliance failure.