Section 857: REIT Taxation and Shareholder Rules

A Real Estate Investment Trust (REIT) is an entity that owns, operates, or finances income-producing real estate. REITs receive special tax treatment under the Internal Revenue Code, allowing them to function like a mutual fund for real estate. This structure provides a way for individuals to invest in large-scale properties. The tax rules are designed to pass benefits through to investors by governing how the entity qualifies and how shareholders are taxed.

REIT Qualification Requirements

An entity must satisfy a series of tests, primarily found in Internal Revenue Code Section 856, to qualify for and maintain its status as a REIT. These requirements ensure the entity is focused on real estate activities and that its ownership is widely dispersed, addressing its organization, income sources, and asset composition.

Organizational Structure

A REIT must be organized as a taxable U.S. corporation, association, or trust. It must be managed by a board of directors or trustees, and its shares must be fully transferable. After its first year, a REIT must have at least 100 shareholders. To prevent concentrated ownership, no more than 50% of its shares can be held by five or fewer individuals during the last half of the taxable year.

Income Tests

A REIT must meet two annual income tests to demonstrate its focus on passive real estate investments. The 75% income test requires at least 75% of the REIT’s gross income to be from real estate-related sources, including rents from real property, interest on mortgages secured by real property, and gains from the sale of certain real estate assets. The 95% income test mandates that at least 95% of gross income must come from sources qualifying for the 75% test, plus other passive income like dividends and interest from non-real estate sources.

Asset Tests

A REIT must satisfy several asset tests at the close of each quarter. The 75% asset test requires that at least 75% of the value of the REIT’s total assets consist of real estate assets, cash, and government securities. The remaining 25% of assets are subject to diversification rules. Under these rules, a REIT cannot hold securities from a single issuer that account for more than 5% of its total assets, nor can it own more than 10% of the outstanding voting securities of any one issuer.

The Annual Distribution Mandate

A feature of the REIT structure, detailed in Internal Revenue Code Section 857, is the requirement to distribute most of its earnings to shareholders annually. By distributing this income as dividends, the REIT can deduct these payments, avoiding corporate-level tax. The tax liability instead passes to the shareholders who receive the distributions.

To maintain its tax-advantaged status, a REIT must distribute at least 90% of its taxable income to its shareholders annually. This income is calculated before accounting for the dividends paid deduction and excludes any net capital gains. This ensures that nearly all operational profits are passed on to investors.

Distributions are made as dividends, and timing rules provide flexibility. A dividend declared in the final quarter of a year can be treated as paid on December 31, even if paid in January of the next year. A REIT can also declare a dividend in the following year and have it relate back to the prior year’s income to meet the 90% test, provided it is paid before the first regular dividend payment of the current year.

Taxation of REIT Shareholders

The tax implications for a shareholder depend on the character of the income the REIT generated and distributed. The REIT must inform shareholders of the tax breakdown of their distributions, which is done on Form 1099-DIV.

Distributions are categorized in one of three ways:

• Ordinary dividends represent a share of the REIT’s net rental income. These dividends are taxed at the shareholder’s ordinary income tax rate, not the lower qualified dividend rate that applies to many stocks. Through 2025, many taxpayers can deduct up to 20% of their qualified REIT dividends, which can lower the effective tax rate on these distributions.
• Capital gain dividends occur when a REIT sells a property for a profit and passes that gain to its investors. Shareholders report these as long-term capital gains, which are taxed at preferential capital gains rates, regardless of how long the shareholder has owned the REIT stock. The REIT must designate these distributions as capital gain dividends.
• A return of capital is not immediately taxable. Instead, it reduces the shareholder’s cost basis in their shares. For example, if an investor paid $50 per share and receives a $2 per share return of capital, their new cost basis becomes $48. Once the basis is reduced to zero, further distributions are taxed as capital gains.

Consequences of Non-Compliance

If a company fails to meet the qualification or distribution rules, the primary consequence is the loss of its REIT tax status. The disqualification applies to the tax year in which the failure occurred and potentially for subsequent years.

A disqualified REIT is taxed as a standard C corporation, subjecting its income to the corporate tax rate. The entity can no longer deduct dividends paid to shareholders, which results in double taxation where income is taxed at the corporate level and again when distributed to shareholders.

Following a disqualification, an entity is barred from re-electing REIT status for four years. However, the law provides relief for some unintentional failures. For example, if a REIT fails the 90% distribution test, it may use a “deficiency dividend” procedure to make a catch-up distribution in a later year and avoid disqualification for the past year.