What Are the Quarterly REIT Asset Tests?

A Real Estate Investment Trust, or REIT, is an entity that owns, and in most cases operates, income-producing real estate. To qualify for this designation, which allows the entity to pass income through to its shareholders without being taxed at the corporate level, it must adhere to strict requirements set forth by the Internal Revenue Code. Among the most important of these are the quarterly asset tests.

These tests are performed at the close of each quarter of a REIT’s taxable year to ensure that a REIT is predominantly invested in real estate assets. They are a snapshot of the entity’s holdings, verifying that its portfolio composition aligns with the regulatory framework. Failure to meet these tests can jeopardize a REIT’s tax-advantaged status, making ongoing compliance a focus for its management.

The 75 Percent Real Estate Asset Test

The 75 percent asset test is a foundational requirement detailed in the Internal Revenue Code. This rule mandates that at the close of each quarter, at least 75% of the value of a REIT’s total assets must be composed of real estate assets, cash and cash items, and government securities. This test serves as the primary mechanism to ensure that a REIT’s investments are concentrated in the real estate sector.

The definition of “real estate assets” is comprehensive and forms the bulk of the qualifying assets for this test. It includes direct ownership of real property, which encompasses land and the improvements on it, such as buildings. It also extends to interests in mortgages secured by real property, and shares in other REITs are considered qualifying real estate assets.

Beyond direct real estate holdings, the test allows for the inclusion of cash, cash items, and government securities within the 75% threshold. Cash and cash items are understood to include currency, demand deposits, and other short-term, highly liquid investments. Government securities, as defined under the Investment Company Act of 1940, also count toward this total.

The practical application of this test requires a REIT to meticulously track the value of its assets on a quarterly basis. For instance, personal property leased in connection with real property will be treated as a qualified real estate asset, but only if the rent attributable to that personal property does not exceed 15% of the total rental income for the combined property.

Diversification Asset Tests

Beyond the 75% test, a REIT must also satisfy several diversification tests that apply to the remaining 25% of its asset base. These rules are designed to prevent a REIT from concentrating its non-real estate investments too heavily in any single entity or security. They promote risk management within the portion of the portfolio not dedicated to core real estate assets.

The 20 Percent TRS Test

No more than 20% of the value of a REIT’s total assets may be represented by the securities of one or more taxable REIT subsidiaries (TRSs). A TRS is a separate corporation that can provide services to the REIT’s tenants or third parties and engage in activities that the REIT itself cannot, such as property management for third parties, without generating non-qualifying income for the REIT. This test caps the REIT’s exposure to these related business activities.

The 5 Percent Asset Test

This rule stipulates that no more than 5% of the value of the REIT’s total assets can be invested in the securities of any single issuer. This prevents the REIT from having a significant concentration in the stock or bonds of one particular company outside of its TRS investments. It forces the REIT to spread its non-real estate investments across multiple entities.

The 10 Percent Ownership Test

Complementing the 5% test is the 10% test, which focuses on control. A REIT is prohibited from owning more than 10% of the total voting power or the total value of the outstanding securities of any one issuer. This restriction prevents the REIT from exercising significant influence or control over other corporations through its security holdings.

Asset Valuation for Quarterly Testing

The quarterly tests are conducted using the fair market value of the REIT’s assets as of the last day of each quarter. This “snapshot” approach provides a periodic check-up on the REIT’s compliance. The valuation itself is based on gross assets determined under U.S. Generally Accepted Accounting Principles (U.S. GAAP).

A key aspect of the valuation process is a safe harbor provision related to market fluctuations. A REIT that meets the asset tests at the close of a quarter will not fail those tests in a subsequent quarter simply because of changes in the market value of its assets. For a compliance failure to occur, the discrepancy must be wholly or partly the result of the REIT acquiring a new security or asset.

To illustrate this principle, consider a REIT that is fully compliant at the end of a quarter. If, during the next quarter, the value of a non-qualifying stock it holds increases dramatically and pushes its value above the 5% threshold, the REIT does not automatically fail the test. The failure would only be triggered if the REIT actively acquires another non-qualifying asset or security during that same quarter.

This safe harbor underscores the importance of due diligence at the time of any new acquisition. Before purchasing any new asset, a REIT must assess the impact of the acquisition on its compliance with all asset tests.

Addressing Asset Test Failures

When a REIT identifies a failure to meet one of the asset tests at the end of a quarter, specific cure provisions within the Internal Revenue Code allow it to correct the issue and avoid disqualification.

The 30-Day Cure Period

The primary remedy is a 30-day cure period. A REIT has 30 days from the close of the quarter in which the discrepancy was identified to eliminate the non-compliance. This typically involves disposing of the non-qualifying asset or assets that caused the failure, thereby bringing the portfolio back into alignment with the required percentages.

De Minimis Failures

For failures not corrected within this 30-day window, additional relief provisions may be available for minor, or “de minimis,” failures. This relief applies if the failure is due to owning assets that, in total, do not exceed the lesser of 1% of the total value of the REIT’s assets at the end of the quarter or $10 million. To qualify, the REIT must dispose of the non-compliant assets within six months and file a detailed schedule describing the assets with the IRS.

Failures Due to Reasonable Cause

In cases of more significant failures, a REIT may still find relief if it can demonstrate that the failure was due to reasonable cause and not willful neglect. If reasonable cause is established, the REIT must dispose of the problematic assets, file the required schedule with the IRS, and may be required to pay a penalty tax. This tax is imposed on the net income generated by the non-qualifying assets.