What Is the Total Revenue Test for REITs and RICs?

The Total Revenue Test is a fundamental compliance measure for specific investment vehicles in the United States. This test ensures that entities receiving favorable tax treatment primarily generate income from sources consistent with their intended purpose. Adherence to this test is necessary for maintaining their special tax status and associated benefits, thereby avoiding higher corporate-level taxation.

Understanding the Total Revenue Test

The Total Revenue Test ensures that Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs) derive the vast majority of their gross income from specified qualifying sources. This requirement allows these entities to qualify for distinct tax treatments, generally involving the avoidance of corporate income tax on distributed earnings. The underlying rationale is to ensure that REITs remain primarily engaged in real estate activities and RICs in investment activities, consistent with their design as pass-through vehicles for investors.

REITs are entities that own, operate, or finance income-producing real estate. The Total Revenue Test for REITs ensures that their income is predominantly derived from real estate-related activities, preventing them from operating as traditional businesses that would otherwise be subject to corporate tax. Similarly, RICs, which include mutual funds and exchange-traded funds (ETFs), pool money from investors to invest in a diversified portfolio of securities. The test for RICs ensures that their income primarily originates from investments, allowing them to pass through investment income and capital gains to shareholders without being taxed at the entity level.

This test is an annual requirement to confirm ongoing compliance with the Internal Revenue Code provisions that grant their unique tax status. Without these income source restrictions, the beneficial tax treatment afforded to REITs and RICs could be exploited by entities not genuinely engaged in the activities for which the tax benefits were designed.

Revenue Components for the Test

The Total Revenue Test scrutinizes the types of income an entity generates to determine its qualification. For Real Estate Investment Trusts (REITs), the test involves two primary income thresholds: a 75% gross income test and a 95% gross income test. The 75% test mandates that at least 75% of a REIT’s gross income must come from real property-related sources. These qualifying sources include rents from real property, interest on obligations secured by mortgages on real property, gain from the sale or other disposition of real property, and income from foreclosure property. It also includes dividends from other REITs and abatements and refunds of real estate taxes.

The 95% gross income test for REITs is broader, requiring at least 95% of their gross income to be derived from the sources qualifying for the 75% test, along with additional passive income sources. These additional sources primarily encompass dividends, interest from non-mortgage sources, and gains from the sale or disposition of stock or securities. Income excluded from these tests generally includes income from “prohibited transactions,” such as sales of property held primarily for sale to customers in the ordinary course of business. Also excluded is impermissible tenant service income, which is income from services not customarily furnished in connection with the rental of real property.

For Regulated Investment Companies (RICs), the income test requires that at least 90% of their gross income for the taxable year must be derived from dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock, securities, or foreign currencies. This also includes other income derived from investing in such assets, such as gains from options, futures, or forward contracts. The purpose of these specific inclusions and exclusions is to ensure that RICs focus on their core function of investment management, rather than engaging in active trade or business operations.

Meeting the Total Revenue Test Requirements

Meeting the Total Revenue Test requirements is crucial for Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs) to retain their favorable tax treatment. For REITs, the specific thresholds are that at least 75% of their gross income must be from real estate sources, and at least 95% of their gross income must be from real estate sources, dividends, interest, or gains from the sale of stock or securities. Compliance with these gross income tests is measured annually.

Similarly, Regulated Investment Companies (RICs) must derive at least 90% of their gross income from qualifying investment sources such as dividends, interest, and gains from the sale of securities. This annual assessment determines whether the entity continues to operate as a passive investment vehicle or a real estate holding entity. The Internal Revenue Service (IRS) scrutinizes these percentages to ensure adherence to the legislative intent behind the special tax status.

Successfully meeting these income tests allows REITs and RICs to avoid corporate-level income tax on the income they distribute to their shareholders. This pass-through treatment means that the income is taxed only once, at the shareholder level, which can enhance investor returns. Both REITs and RICs are required to distribute a substantial portion of their taxable income, 90% or more, to their shareholders to maintain this tax-advantaged status.

Conversely, failing to meet the Total Revenue Test can have significant negative consequences. If a REIT or RIC fails to satisfy the gross income tests, it risks losing its special tax status and becoming subject to corporate income tax on all its earnings, similar to a standard C-corporation. This outcome can lead to double taxation, where income is taxed at both the entity level and again when distributed to shareholders, severely diminishing investor returns. While some inadvertent failures may be cured, they involve penalties or require corrective actions to regain compliance.