A real estate investment trust (REIT) lets investors own income-producing real estate through shares. REITs get special tax treatment. However, to form a real estate investment trust, a company must meet strict organizational, operational, distribution and compliance rules. Here is a general summary.
How a real estate investment trust must be organized
A U.S. REIT must be formed in one of the 50 states or the District of Columbia. In addition, it must be an entity taxed as a corporation for federal purposes. Directors or trustees must manage it, and its shares must be transferable.
Starting with its second tax year, a REIT must also pass two ownership tests:
- 100-shareholder test. The REIT must have at least 100 shareholders.
- 5/50 test. Five or fewer individuals can’t own more than 50% of the REIT’s stock value during the last half of the year.
To stay within these tests, most REITs limit how much stock any one person can own. Because the tests are complex, talk with tax and securities advisors before you form a REIT.
How a REIT operates: income and asset tests
Each year, a REIT must pass two income tests. Also, it must pass several asset tests every quarter. Together, these tests make sure most of its income and assets come from real estate.
Income tests
- At least 75% of gross income must come from real estate sources. For example, these include rents from real property and interest on mortgage loans.
- At least 95% must come from those sources plus other passive income, such as dividends and interest.
- So no more than 5% can come from other sources, such as service fees or a non-real estate business.
Asset tests
- At least 75% of the REIT’s assets must be real estate assets, cash or government securities.
- A REIT generally can’t own more than 10% of the voting securities or value of another company. However, this limit doesn’t apply to other REITs, taxable REIT subsidiaries (TRSs) or qualified REIT subsidiaries.
- Similarly, stock in any one such company can’t exceed 5% of the REIT’s assets.
- Finally, TRS securities can’t exceed a set share of total assets. The 2025 tax law raised this limit from 20% to 25% for tax years beginning after 2025.
REIT dividend distribution rules
A REIT must distribute at least 90% of its taxable income to shareholders each year. If it keeps any income, it pays corporate tax on that amount, like any other corporation.
Compliance rules for a real estate investment trust
A company elects REIT status by filing its income tax return on Form 1120-REIT. Because the return is filed after year-end, the election also comes after the first year ends. Even so, the company must pass the REIT tests during that first year. The only exceptions are the 100-shareholder and 5/50 tests, which start in year two.
In addition, a REIT must send yearly letters to shareholders asking who owns its shares. Missing these letters can bring significant penalties.
Get help forming a REIT
Forming a REIT takes careful tax planning, from the ownership tests to the first-year election. Our team can help you structure the entity and stay compliant. To discuss your plans, call us at (415) 842-2940, email support@flextcg.com or book a free 15-minute call.