ABCs of REITs (2024)

Areal estate investment trust (REIT)is a complex entity designed to provide all investors the opportunity to invest in commercial real estate in a tax efficient manner. REITs have become a popular investment vehicle around the world.

The REIT industry has a diverse profile and can be broadly grouped into two categories:

  1. Equity REITs predominantly own and operate real estate
  2. Mortgage REITs generally lend money directly to real estate owners and operators

While REITs differentiate themselves through various characteristics, all REITs must follow the same regulations under federal tax law.

General requirements

Ownership

To qualify as a REIT, an organization must be a corporation, trust or association. A REIT cannot be a financial institution or an insurance company and it must be managed by one or more trustees or directors. The REIT’s ownership (which must be proven by transferable shares or by transferable certificates of beneficial interest) must be held by at least 100 shareholders for at least 335 days of a 365-day calendar year (or equivalent thereof for a short tax year) for the second taxable year and beyond.

A REIT cannot be closely held. A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year, (this is commonly referred to as the 5/50 test). Spouses and certain other family members are aggregated and count as one individual for this purpose.

Dividends

A REIT is required to pay a dividend of at least 90 percent of its taxable income each year. A dividend is any distribution of cash or property made by a corporation to its shareholders out of its earnings and profits from the current taxable year and then from accumulated earnings and profits from prior years. If there are no earnings and profits available for a distribution, the distribution is considered a return of capital for the shareholder and is therefore nontaxable to the extent the shareholder has basis in the REIT shares.

Asset and income tests

A REIT is subject to different income and asset tests. These tests, in conjunction with all of the other REIT rules, mean that only certain assets can be held in a REIT.

Asset tests

Asset tests are completed on a quarterly basis; 75 percent of the value of a REIT’s total assets must be represented by real estate assets, cash, cash items and government securities. Real estate assets specifically include real property, interests in mortgages on real property or real estate mortgage investment conduits.

Diversification is also required as part of the asset test. No more than:

  • 5 percent of the value of the REIT’s total assets may consist of securities of any one issuer, except with respect to a taxable REIT subsidiary
  • 10 percent of the outstanding vote or value of the securities of any one issuer may be held (again, a taxable REIT subsidiary is an exception to this requirement)
  • 25 percent of the total assets can be securities
  • 25 percent of the REIT’s total assets may consist of one or more taxable REIT subsidiaries (the Protecting Americans from Tax Hikes Act reduces this requirement to 20 percent as of Jan. 1, 2018)

Income tests

Along with the asset tests, REITs must also comply with annual income tests. For practical purposes, it is in the REIT’s best interest to test income on a quarterly basis in conjunction with the asset tests. These income tests are based on the gross income from the various properties that the REIT owns. There are two income tests: the 75 percent test and the 95 percent test.

The 75 percent test is comprised solely of real estate income. At least 75 percent of a REIT’s gross income must be derived from rents from real property, interest on obligations secured by mortgages on real property, dividends from other REITs, and gain from the sale or other disposition of real property. Rents from real property is defined to include rents; charges for services customarily furnished in connection with rental of real property; and generally rent attributable to personal property which is leased in connection with a lease of real property. Impermissible tenant service income is excluded from rents from real property. A taxable REIT subsidiary (TRS) is primarily used to allow the REIT to provide otherwise non-qualifying services.

REITs must also comply with the 95 percent test. While this test has less margin for error, it also allows for a greater variety of sources of income. This test includes both real estate and portfolio income. All of the real estate income from the 75 percent test is included in the 95 percent test. Interest income, dividend income, and gain from the sale or disposition of stock and securities are also included.

Prohibited transactions

A prohibited transaction is a sale or other disposition of property that is held primarily for sale to customers in the ordinary course of a trade or business. Net income from prohibited transactions is taxed at 100 percent for REITs. There are certain safe harbors to follow in order to avoid a sale being deemed a prohibited transaction. Prohibited transactions are a common issue about which REIT stakeholders must be aware because the penalties can be severe. Proper documentation and planning before a REIT acquires and disposes of a property, however, can diminish the REIT’s exposure.

To REIT or not to REIT?

Whether or not a REIT makes sense for your company depends heavily on the makeup of your investors and their preferences. As noted, a REIT distributes earnings to shareholders in the form of a dividend. At the same time, the REIT is entitled to a dividends-paid deduction. From a tax perspective, this holds a significant benefit. Although a REIT is generally taxed as a corporation, the REIT can avoid paying entity-level federal income tax through the use of the dividends-paid deduction to offset its otherwise taxable income.

Tax-exempt or foreign investors:

The presence of a REIT is very attractive to tax-exempt investors. While these investors are generally exempt from paying federal tax by definition, many may still be subject to unrelated business income tax on their share of debt-financed real estate income.

On the contrary, dividends issued by REITs are generally excluded from unrelated business taxable income. Similar benefits can also apply to foreign investors who may be able to use a REIT vehicle to mitigate US reporting and tax withholding on dividend income and ultimate disposition of REIT stock.

Individual investors:

REITs offer exciting opportunities to the average taxable investor as well. REITs offer diversification by investing in many different property types across all parts of the world. REITs provide yield in the form of dividends.

As noted earlier, REITs are required to distribute at least 90 percent of their taxable income to shareholders. REITs simplify state tax reporting for individuals since the state income tax consequences and filing requirements of multistate real estate portfolios do not pass through the REIT to the investor. The shareholders simply recognize dividend income and pay tax in their state of residence.

If the property is directly owned by an individual:

While the allure of not paying taxes is attractive, REITs may not be the best vehicle for an individual who directly owns property. The general organization requirements are significant hurdles.

While the 100 shareholder test can be easily administered, the 5/50 test requires a significant diversification of ownership that often deters owners that own a majority stake in real estate.

An attractive option, with rules

REITs are becoming an increasingly popular option in real estate. But along with the many valuable benefits come strict compliance rules that must be considered. Ignoring or misinterpreting these rules can significantly affect a REIT and its owners. With proper structuring and ongoing monitoring, the utilization of a REIT may be an attractive implementation for your next real estate investment.

ABCs of REITs (2024)

FAQs

What is the 90% rule for REITs? ›

To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.

What is the 75% rule for REITs? ›

For each tax year, the REIT must derive: at least 75 percent of its gross income from real property-related sources; and. at least 95 percent of its gross income from real property-related sources, dividends, interest, securities, and certain mineral royalty income.

What is the 5 50 rule for REITs? ›

General requirements

A REIT cannot be closely held. A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year, (this is commonly referred to as the 5/50 test).

What is the REIT 10 year rule? ›

For Group REITs, the consequences of leaving early apply when the principal company of the group gives notice for the group as a whole to leave the regime within ten years of joining or where an exiting company has been a member of the Group REIT for less than ten years.

What is the 75 75 90 rule for REITs? ›

Invest at least 75% of its total assets in real estate. Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Pay at least 90% of its taxable income in the form of shareholder dividends each year.

How much of my retirement should be in REITs? ›

“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio. Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any.

What is the 48 hour clause for REITs? ›

This condition allows the seller to continue advertising the property. If the seller receives another offer, the buyer will have 48 hours to revise their offer, making it unconditional regarding the sale of their property.

What is bad income REIT rules? ›

In order for an entity to maintain REIT status, it is subject to a series of quarterly and yearly tests, including two income tests: a 75% test and a 95% test. If the REIT has too much non-qualifying income it is at risk of failing these tests.

What is better than REITs? ›

Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making. Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.

Which type of REIT is best? ›

The Best REITs to Buy
  • Ventas Inc. (VTR)
  • Macerich Co. (MAC)
  • Healthpeak Properties Inc. (DOC)
  • Park Hotels & Resorts Inc. (PK)
  • Pebblebrook Hotel Trust. (PEB)
May 13, 2024

How many investors must a REIT have? ›

To ensure compliance with these tests, most REITs include percentage ownership limitations in their organizational documents. Due to the need to have 100 shareholders and the complexity of both of these tests, it is strongly recommended that tax and securities law counsel are consulted before forming a REIT.

How to tell if a REIT is good? ›

The 3 most common metrics used to compare the relative valuations of REITs are:
  1. Cap rates (Net operating income / property value)
  2. Equity value / FFO.
  3. Equity value / AFFO.
Feb 20, 2024

Can a REIT own another REIT? ›

There are a number of situations under which a REIT may own a majority of another REIT's stock that are not within the scope of the perceived abuses targeted by the Administration's proposal. For example, in a tender offer one REIT might own for a period of time more than half of another REIT's stock.

How is REIT income taxed? ›

The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37% (returning to 39.6% in 2026), plus a separate 3.8% surtax on investment income. Taxpayers may also generally deduct 20% of the combined qualified business income amount which includes Qualified REIT Dividends through Dec.

Why do REITs pay 90% dividends? ›

Yet, some REITs like Realty Income Corp (O ) do, in fact, follow the 90% rule because it provides other benefits. In general, REITs do not pay taxes at the trust level insofar as they distribute 90% of their income to shareholders. Of course, REITs that follow this rule still pay corporate taxes on any retained income.

What is the 30% rule for REITs? ›

30% Rule. This rule was introduced with the Tax Cut and Jobs Act (TCJA) and is part of Section 163(j) of the IRS Code. It states that a REIT may not deduct business interest expenses that exceed 30% of adjusted taxable income. REITs use debt financing, where the business interest expense comes in.

What is the payout rule for REIT? ›

To qualify as securities, REITs must payout at least 90% of their net earnings to shareholders as dividends. For that, REITs receive special tax treatment; unlike a typical corporation, they pay no corporate taxes on the earnings they payout.

What is the minimum investment required for REIT? ›

While they aren't listed on stock exchanges, non-traded REITs are required to register with the SEC and are subject to more oversight than private REITs. According to the National Association of Real Estate Investment Trusts (Nareit), non-traded REITs typically require a minimum investment of $1,000 to $2,500.

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