What Is a Taxable REIT Subsidiary and How Does It Operate?

Real estate investment trusts (REITs) primarily generate passive income from real estate holdings, but they can establish taxable REIT subsidiaries (TRS) to engage in otherwise restricted activities. A TRS enables a REIT to expand operations while maintaining compliance with tax regulations.

Key Requirements for TRS Formation

A TRS must comply with federal tax regulations to avoid jeopardizing the REIT’s tax status. Under Internal Revenue Code (IRC) Section 856(l), a REIT must own stock in the subsidiary, either directly or indirectly. Both entities must file IRS Form 8875, “Taxable REIT Subsidiary Election,” to notify the IRS of the TRS designation. This election remains in effect until revoked or terminated; failure to file properly results in the subsidiary being treated as a regular C corporation, subject to different tax treatment.

A TRS operates as a separate taxable entity and is subject to the 21% federal corporate income tax rate under the Tax Cuts and Jobs Act of 2017. Unlike a REIT, which benefits from pass-through taxation, a TRS does not receive preferential tax treatment. This allows it to engage in activities that would otherwise disqualify the REIT from its tax-advantaged status, but it must maintain independent financial records and file its own corporate tax returns.

Transactions between a REIT and its TRS must be conducted at fair market value to prevent tax avoidance. Under IRC Section 856(l)(3), if the IRS determines that income has been improperly shifted, a 100% excise tax may be imposed on non-arm’s-length transactions. This rule applies to services such as property management, leasing, and operational agreements.

Equity Ownership Structure

A REIT can own up to 100% of a TRS’s stock, giving it full control over the subsidiary’s operations. This ownership structure allows the REIT to expand into business areas that would otherwise disqualify it from maintaining its tax-advantaged status. If the TRS is jointly owned with another entity, the REIT’s stake must be managed carefully to ensure compliance with IRS regulations.

To prevent excessive reliance on taxable subsidiaries, the IRS limits the proportion of a REIT’s total assets that can be allocated to TRS investments. Under IRC Section 856(c)(4)(B)(ii), a REIT cannot hold securities of one or more TRS entities that, in aggregate, exceed 20% of its total assets. Exceeding this threshold risks loss of preferential tax treatment.

Transactions between a REIT and its TRS must be conducted at arm’s length to prevent improper income shifting. The IRS monitors these interactions to ensure the TRS is not used to shelter income from taxation. If a TRS provides services to the REIT at below-market rates, penalties, including a 100% excise tax, may be imposed.

Permissible Business Activities

A TRS allows a REIT to engage in revenue-generating activities beyond passive real estate ownership. One primary function is offering tenant services that a REIT itself is prohibited from directly providing. For example, a TRS can operate hotel management companies, senior living facilities, or provide concierge services in apartment complexes. Since these services go beyond basic leasing and maintenance, they would normally disqualify a REIT from tax-efficient status if performed directly. By channeling these operations through a TRS, the REIT can generate additional revenue while remaining compliant with tax regulations.

A TRS can also engage in real estate-related businesses such as property development and brokerage services. While a REIT is primarily restricted to holding and managing income-producing real estate, its subsidiary can actively buy, develop, and sell properties for profit. For example, a TRS could acquire land, construct a commercial building, and sell it at a gain—an activity that would otherwise jeopardize a REIT’s tax status if conducted directly. Additionally, the TRS can provide real estate financing, such as originating and servicing mortgage loans, further expanding the REIT’s investment capabilities.

A TRS may also participate in joint ventures with third parties, allowing the REIT to invest in business operations that would be off-limits under REIT regulations. This is particularly useful for developing mixed-use properties that include retail, hospitality, or other taxable business components. Through a TRS, the REIT can maintain an interest in the venture without violating the requirement that at least 75% of its income must come from real estate-related sources.

Restrictions on TRS Operations

A TRS must operate within strict regulatory constraints to prevent abuse of its tax status. One major restriction involves earnings stripping, where excessive interest payments are made from the TRS to the REIT or its affiliates to reduce taxable income. The IRS monitors these transactions to ensure they reflect fair market terms and do not serve as a mechanism for shifting profits away from the fully taxable TRS. Under IRC Section 163(j), interest deductions may be limited if they exceed 30% of the TRS’s adjusted taxable income.

A TRS also cannot directly own properties leased back to the REIT or engage in activities that result in indirect self-dealing. The IRS enforces a 100% excise tax on any transactions that involve improper rent allocations between the REIT and its TRS. This prevents a TRS from being used to shelter taxable income through artificially low lease payments or other favorable terms that do not reflect arm’s-length negotiations.

Tax Filing and Compliance Duties

A TRS operates as a separate taxable entity and must fulfill independent tax filing and reporting obligations. Unlike a REIT, which benefits from pass-through taxation if it meets distribution requirements, the TRS is subject to corporate income tax on its earnings.

The TRS must file Form 1120, U.S. Corporation Income Tax Return, annually with the IRS, reporting its taxable income, deductions, and credits. Since the TRS is taxed as a C corporation, it is subject to the 21% federal corporate tax rate. Additionally, state corporate income taxes may apply depending on where the TRS operates. Some states impose franchise or gross receipts taxes, which must be factored into financial planning. Estimated quarterly tax payments to the IRS are required if the TRS expects to owe more than $500 in taxes for the year.

The IRS also requires that any intercompany transactions, such as management fees or service agreements, be conducted at arm’s length to prevent income shifting. If the IRS determines that a TRS has underreported taxable income through improper pricing, it can impose adjustments and penalties. Additionally, the TRS must comply with withholding tax requirements if it makes payments to foreign entities or shareholders.

Dividend and Distribution Procedures

A TRS has greater flexibility in distributing earnings compared to its parent REIT. Unlike a REIT, which must distribute at least 90% of its taxable income to maintain its tax status, a TRS has no mandatory distribution requirement. This allows it to retain earnings for reinvestment or strategic expansion.

When a TRS distributes dividends to its REIT owner, these payments are classified as ordinary dividends and taxed at the corporate level before being received by the REIT. The REIT, in turn, must report these dividends as taxable income unless it qualifies for a dividends-received deduction under certain circumstances. To minimize tax inefficiencies, many REITs structure TRS dividend payments strategically, balancing reinvestment needs with tax liabilities. If the TRS distributes earnings to non-REIT shareholders, those dividends may be eligible for the qualified dividend tax rate, which is lower than ordinary income tax rates for individual investors.