What Are the Requirements to Qualify for REIT Status?
Understand the detailed framework of financial and organizational rules that define a company as a REIT and enable its special pass-through tax treatment.
A Real Estate Investment Trust, or REIT, is an entity that owns and often operates income-generating real estate. This structure provides a tax benefit by allowing the entity to pass its corporate income tax obligations to its shareholders. This is done by distributing the majority of its taxable income as dividends. The investors are then taxed at their individual income tax rates, avoiding the double taxation common to standard corporations.
Organizational and Shareholder Requirements
To qualify for REIT status, an entity must meet several organizational requirements. It must be structured as a corporation, trust, or association that would otherwise be taxable as a domestic U.S. corporation. The structure must be managed by one or more trustees or directors, and its ownership interest must be represented by transferable shares.
A REIT must also satisfy two shareholder tests after its first year. The “100-shareholder test” requires the REIT to have at least 100 shareholders for a minimum of 335 days during a 12-month tax year. This rule is waived for the first year an entity elects REIT status and ensures a broad ownership base.
The second rule is the “5/50 test,” which addresses ownership concentration. This test stipulates that during the last half of the taxable year, no more than 50% of the value of the REIT’s outstanding shares can be owned by five or fewer individuals. The IRS applies constructive ownership rules, which consider stock owned by family members or related entities.
Income and Asset Tests
A REIT must meet annual income tests to ensure its earnings are primarily from real estate. The 75% Gross Income Test mandates that at least 75% of gross income must come from sources like real property rents, mortgage interest, gains from real estate sales, and dividends from other REITs.
The 95% Gross Income Test requires that at least 95% of gross income comes from sources qualifying for the 75% test, plus other passive income. These additional sources include dividends, interest, and gains from the sale of stocks and securities. Income from non-customary services to tenants can jeopardize REIT status if it exceeds 5% of gross income.
A REIT must also satisfy 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. Real estate assets include real property and interests in mortgages on real property.
Other diversification rules apply to the remaining 25% of assets. A REIT generally cannot own more than 10% of the voting securities of any single issuer, and these securities cannot exceed 5% of the REIT’s total assets. An exception exists for a Taxable REIT Subsidiary (TRS), which can provide non-customary services to tenants, but the securities of all TRSs cannot exceed 20% of the REIT’s total asset value.
Annual Distribution Requirement
A requirement for maintaining REIT status is the annual distribution of earnings to shareholders. Failure to meet this distribution threshold can result in the entity being taxed as a standard corporation, losing its tax-advantaged status.
To comply, a REIT’s annual distribution must equal or exceed 90% of its REIT taxable income and 90% of its net income from foreclosure property. For this calculation, REIT taxable income is determined without the deduction for dividends paid and excludes any net capital gains.
This distribution must be paid in the applicable year, though under certain conditions it can be paid in the following year if declared before the REIT files its tax return. The dividends must be classified as ordinary dividends, not capital gain dividends, to count toward the requirement.
Electing and Reporting REIT Status
An entity elects to be treated as a REIT by computing its taxable income as such on its first tax return, Form 1120-REIT. Once made, the election remains in effect for subsequent years unless it is terminated or revoked.
To maintain its status, a REIT must file Form 1120-REIT annually to demonstrate ongoing compliance with all tests. This process involves verifying shareholder ownership to ensure compliance with the 100-shareholder and 5/50 tests. REITs must keep records of ownership and send annual letters to certain shareholders requesting statements of their holdings.
The tax code provides mechanisms to correct some compliance failures. If a REIT fails its distribution requirement due to an audit, it can use a “deficiency dividend” procedure. This allows the REIT to pay an additional dividend in a later year to fix the shortfall and preserve its status, though it requires paying interest and a penalty.