Section 856 of the Internal Revenue Code: REIT Requirements

Section 856 of the Internal Revenue Code establishes the definitive rules for a corporation or trust to qualify as a Real Estate Investment Trust (REIT). By meeting these requirements, an entity can avoid income tax at the corporate level by distributing the vast majority of its taxable income to its shareholders. The primary benefit of this structure is the elimination of the double taxation that affects standard corporations, where income is taxed first at the corporate level and again when distributed to shareholders as dividends. For a REIT, the income flows through to the shareholders, who are then taxed on the dividends they receive at their individual income tax rates.

Organizational and Ownership Requirements

To be considered for REIT status, an entity must satisfy specific organizational and ownership requirements. The entity must be structured as a U.S. corporation, trust, or association that would otherwise be taxed as a domestic corporation. This structure must be managed by one or more trustees or directors, and its beneficial ownership must be evidenced by transferable shares or certificates.

After its first taxable year, a REIT must meet two ownership tests. The “100-shareholder test” mandates that ownership be held by 100 or more persons for at least 335 days of a 12-month taxable year. The “5/50 test” stipulates that no more than 50% of the value of the REIT’s outstanding shares can be owned by five or fewer individuals during the last half of the taxable year. These rules prevent ownership concentration and reinforce the public nature of the investment.

Asset Qualification Tests

A REIT must continuously monitor the composition of its assets to comply with tests measured at the close of each quarter. These tests are designed to confirm that the entity’s investments are predominantly focused on real estate. The 75% Asset Test requires that at least 75% of the value of a REIT’s total assets must consist of real estate assets, cash, and government securities. The Internal Revenue Code defines real estate assets to include real property, interests in mortgages secured by real property, and shares in other REITs.

A series of diversification rules apply to the remaining 25% of a REIT’s assets. A REIT cannot have more than 5% of its total assets invested in the securities of a single issuer or own more than 10% of the outstanding voting securities of any one issuer. Additionally, the value of securities held in one or more Taxable REIT Subsidiaries (TRSs) cannot exceed 20% of the REIT’s total assets.

Income Qualification Tests

In addition to asset composition, a REIT must satisfy two distinct annual income tests to prove its earnings are primarily from passive real estate-related sources. The 75% Gross Income Test mandates that at least 75% of a REIT’s annual gross income must be derived from specific real estate sources. Qualifying income under this test includes rents from real property, interest on obligations secured by mortgages on real property, gains from the sale of real estate assets, and dividends from other REITs.

The 95% Gross Income Test requires that at least 95% of the REIT’s gross income come from the sources that qualify for the 75% test, supplemented by other passive income. These additional sources include dividends, interest from non-real estate sources, and gains from the sale of stocks or securities.

The definition of “rents from real property” is detailed and excludes income tied to the profits of a tenant or income from non-customary services provided to tenants. For example, providing basic utilities is acceptable, but offering hotel-style room service would generate non-qualifying income.

Distribution Requirement and REIT Election

A defining rule for a REIT is its annual distribution requirement. To maintain its tax-advantaged status, a REIT must distribute at least 90% of its taxable income to its shareholders each year in the form of dividends. This requirement is the mechanism that allows the REIT to claim a dividends paid deduction, eliminating its corporate-level tax liability on the income it passes through to investors.

An eligible entity must formally elect to be treated as a REIT. The entity makes the election by computing its taxable income as a REIT on its tax return for the first year it wishes the election to apply. This is accomplished by filing Form 1120-REIT, the U.S. Income Tax Return for Real Estate Investment Trusts. Once made, the election remains in effect for subsequent years unless it is terminated or revoked.