Section 856: What Are the Requirements for a REIT?

A Real Estate Investment Trust (REIT) is an entity that owns, and in most cases operates, income-producing real estate, allowing individuals to invest in large-scale property portfolios. Section 856 of the U.S. Internal Revenue Code establishes the specific requirements an entity must satisfy to qualify for and maintain REIT status.

Qualifying as a REIT provides a tax advantage by allowing the entity to pass income directly to shareholders without being taxed at the corporate level. This pass-through treatment is contingent upon adherence to regulations governing the entity’s structure, assets, and income. Failure to meet these tests can result in tax consequences.

Organizational and Ownership Requirements

To qualify as a REIT, an entity must meet several organizational and ownership benchmarks. It must be structured as a U.S. corporation, trust, or association that would otherwise be taxed as a domestic corporation. Its management must be handled by one or more trustees or directors responsible for overseeing the entity’s activities.

A REIT’s beneficial ownership must be represented by transferable shares or certificates of ownership. The entity must have a minimum of 100 shareholders for at least 335 days of a taxable year. This provision ensures that ownership is widely dispersed.

Furthermore, a REIT cannot be “closely held.” This is defined by the “5/50 rule,” which states that no more than 50% of the value of the REIT’s stock can be owned by five or fewer individuals during the last half of the taxable year.

Asset Qualification Tests

At the close of each quarter, a REIT must ensure its assets comply with composition tests designed to confirm its investments are focused on real estate. The primary test is the 75% asset test, which requires that at least 75% of the REIT’s total asset value must be composed of real estate assets, cash, and government securities. “Real estate assets” is a defined term that includes real property, interests in mortgages on real property, and shares in other REITs.

The remaining 25% of a REIT’s assets are also subject to limitations. A REIT cannot invest more than 5% of its total asset value in the securities of any single issuer. This diversification requirement prevents excessive exposure to one non-real estate company. Additionally, a REIT cannot own more than 10% of the outstanding voting securities of any single issuer.

These asset tests are performed quarterly, and a REIT must monitor its holdings to ensure compliance. If minor fluctuations in market value cause temporary non-compliance, the REIT must rectify the situation to maintain its status.

Income Source Tests

Annually, a REIT must satisfy two income tests to prove its earnings are derived from passive, real estate-related sources. The first is the 75% income test, which requires that at least 75% of the REIT’s gross income must come from specific real estate sources.

Qualifying sources for this test include:

• Rents from real property
• Interest on obligations secured by mortgages on real property
• Gains from the sale of certain real estate assets
• Dividends from other REITs
• Income from foreclosure property

The second requirement is the 95% income test. This mandates that at least 95% of the REIT’s gross income must be derived from the sources that qualify for the 75% test, plus other types of passive income like dividends, interest, and gains from the sale of securities.

An important concept within these tests is the definition of “rents from real property.” This term excludes income dependent on the net income of a tenant. It also excludes rent from a property where the REIT provides non-customary services to tenants, unless it does so through a taxable REIT subsidiary (TRS). Income from “prohibited transactions,” like selling property held for sale in the ordinary course of business, is also excluded.

Annual Distribution Requirements

A primary feature of a REIT is its obligation to distribute a substantial portion of its earnings to shareholders each year. This enables the REIT to claim a dividends paid deduction, avoiding corporate-level income tax on its distributed profits. The main rule is that a REIT must distribute at least 90% of its taxable income to its shareholders annually.

This taxable income is calculated before the dividends paid deduction and excludes any net capital gains. By distributing these earnings, the income is taxed at the shareholder level, creating the pass-through tax treatment central to the REIT structure. Many REITs distribute 100% of their taxable income to eliminate their corporate tax liability.

The distribution must be paid in the applicable year or, under certain conditions, can be declared in the current year and paid in the following year. This ensures a consistent return of capital to investors.

Consequences of Non-Compliance

Failing to meet the requirements can have significant consequences. The primary outcome is the loss of REIT status for the taxable year in which the failure occurred. If an entity is disqualified, it will be taxed as a standard C corporation on its income for that year, eliminating the pass-through benefit.

This results in double taxation, as the entity faces corporate-level taxes and shareholders are taxed again on any dividends received. Once an entity’s REIT election is terminated, it is generally prohibited from re-electing REIT status for five years.

The Internal Revenue Code contains some relief provisions. If a failure to meet an asset or income test is due to reasonable cause and not willful neglect, the entity may avoid disqualification by paying a penalty tax. In other cases of an asset test failure, the REIT has a six-month period to correct the issue. However, relying on these provisions is not a substitute for diligent compliance monitoring.