REIT Income Tests: The 75% and 95% Gross Income Rules

To keep its pass-through tax status, a real estate investment trust must satisfy two annual gross income tests under IRC Section 856(c): at least 75% of gross income has to come from real estate sources, and at least 95% has to come from passive sources like rent, interest, and dividends.¹ The REIT income test is really these two tests read together, and both have to be met every year. Miss either one, and the REIT either pays a penalty tax under a narrow cure provision or loses its status entirely.

The categories look broad at first glance. They aren’t. What counts as “rent from real property” is narrower than the everyday meaning of rent, and a single mischaracterized revenue stream can put the whole structure at risk.

The 75 Percent Test

This is the stricter test and the one that defines the REIT as a real estate vehicle. Qualifying income under the 75% test includes:¹

Rents from real property (subject to important carve-outs described below)
Interest on obligations secured by mortgages on real property or on interests in real property
Gains from selling real property that wasn’t held primarily for sale to customers
Dividends from other qualified REITs and gains from selling their shares
Income and gains from foreclosure property
Commitment fees for agreements to make real property loans or to purchase or lease real property, as long as the fee doesn’t depend on anyone’s income or profits
Abatements and refunds of real property taxes
Qualified temporary investment income earned on newly raised capital during a one-year window

Everything on this list is tied, directly or one step removed, to real property. Prohibited transaction income is excluded entirely from the gross income figure when running the 75% ratio, so it neither helps nor hurts the percentage. It triggers a separate tax, covered further down.

The 95 Percent Test

The second test casts a wider net. At least 95% of gross income has to come from passive sources.¹ Everything that qualifies under the 75% test automatically qualifies here, plus three additional buckets:

Dividends from any source, including ordinary C-corporations with no real estate connection
Interest of any kind, not just mortgage interest — money market funds, Treasury securities, and commercial paper all count
Gains from selling stocks and securities

The remaining 5% can come from almost any source, including fee income or other active business revenue.

The two tests operate independently. A REIT can fail the 75% test while still passing the 95% test. If a REIT earns 70% of its income from real estate sources but 96% from passive sources overall, it fails one and passes the other. Both must be satisfied.

What Counts as Rent From Real Property

Rents from real property are the largest qualifying category for most equity REITs. The statutory definition is narrower than the ordinary meaning of rent, and several rules can strip qualifying status from payments that look, in a lease, exactly like rent.

Rent Cannot Depend on Tenant Profits

Rent that varies with a tenant’s net income or profits is excluded from qualifying rent.¹ Percentage rent tied to the tenant’s gross receipts or sales is allowed. This is common in retail leases where the landlord takes base rent plus a percentage of sales above a set threshold. Gross receipts, acceptable. Net profits, disqualifying.

The 10 Percent Related-Party Rule

Rent from a related tenant does not qualify. The REIT is considered related to a tenant if it directly or indirectly owns:¹

10% or more of the total combined voting power (or 10% or more of the total value) of stock in a corporate tenant
10% or more of the assets or net profits of a non-corporate tenant

The test reaches both direct and indirect ownership, so layered structures don’t get around it.

Impermissible Tenant Services

Rent doesn’t qualify if the REIT furnishes services to tenants beyond what’s customary for the type of property.¹ Maintaining common areas, running elevators, and providing basic building security at an office tower is customary. A concierge desk, catering, or specialized IT support typically is not. Where the line sits depends on what landlords ordinarily provide for that property type in that market.

The penalty structure is deliberately harsh. If impermissible service income from a property exceeds 1% of all amounts the REIT receives from that property during the year, then all of the REIT’s service income from the property is treated as impermissible tenant service income.¹ The all-or-nothing design pushes REITs to keep non-customary services well below the threshold.

Two escape routes exist. Services furnished through an independent contractor from whom the REIT derives no income don’t count as REIT-provided services. Neither do services provided through a taxable REIT subsidiary.¹ Most large REITs route any non-customary service operation through a TRS. The TRS pays corporate tax on its own income; the rent the REIT collects stays clean.

Personal Property Bundled With a Lease

When a REIT leases personal property (furniture, equipment, fixtures) alongside real property under the same lease, the rent attributable to the personal property can still qualify as rent from real property, provided the personal property portion doesn’t exceed 15% of total rent under that lease for the year.¹ Above 15%, the personal property portion drops out of qualifying income, but the real property rent itself remains qualifying.

Qualifying Mortgage Interest

For mortgage REITs, interest on loans secured by real property is the primary 75% category. The obligation has to be secured by real property or an interest in real property.¹ Interest on unsecured loans or loans backed only by personal property doesn’t clear the 75% threshold, though it still counts toward the 95% test as ordinary interest.

The profit-participation restriction that applies to rent applies here too. Qualifying mortgage interest cannot depend on the borrower’s net profits. Interest that varies with the borrower’s gross receipts or sales is fine. Income can scale with a property’s top line, not its bottom line.

Hedging Income

Income from qualifying hedging transactions is excluded from gross income entirely for both tests.¹ Hedging gains don’t count as qualifying income, but they don’t contaminate the calculation as non-qualifying income either. They simply drop out of both sides of the fraction.

To get this treatment, the hedge has to manage interest rate risk on debt incurred to acquire or carry real estate assets, or currency risk on qualifying income or the property generating it. The REIT also has to satisfy the tax code’s identification requirements for hedging transactions. When a REIT partially unwinds a hedge because full termination would be commercially impractical, income from the offsetting counteracting transaction also qualifies for exclusion.

Prohibited Transactions Sit Outside the Income Tests

A prohibited transaction is the sale of property the REIT held primarily for sale to customers in the ordinary course of business. Selling an apartment complex after a decade is normal REIT activity. Buying land, developing it, and flipping it fast looks like a real estate dealership.²

Gains from prohibited transactions face a 100% tax on the net income from the sale.² The REIT keeps nothing after tax. Because prohibited transaction income is also excluded from gross income when computing the 75% and 95% ratios, it sits in its own penalty box outside the income tests. A safe harbor exists for sales that meet holding-period, capital-expenditure, and volume conditions under IRC Section 857, including a two-year minimum hold and either a seven-sale annual cap or a 10% aggregate-basis limit on dispositions.³

Failing an Income Test: The Cure

Missing the 75% or 95% test doesn’t automatically end REIT status. The code allows a cure, but it takes two things: the failure has to be due to reasonable cause rather than willful neglect, and the REIT has to file a schedule with its tax return listing every item of gross income in the categories relevant to the failed test.¹

If both conditions are met, the REIT stays qualified but owes a penalty tax. The penalty equals the greater of two shortfall amounts:³

The excess of 95% of gross income over the amount actually derived from 95%-qualifying sources, or
The excess of 75% of gross income over the amount actually derived from 75%-qualifying sources

Whichever shortfall is larger is multiplied by a profitability fraction: the REIT’s taxable income divided by its gross income, with adjustments for capital gains and foreclosure property. The result is the penalty owed. For a profitable REIT that misses by a wide margin, the bill can be substantial, but far less catastrophic than losing status.

When REIT Status Terminates

If the failure was willful, or the REIT can’t demonstrate reasonable cause, or it doesn’t file the required income schedule, the REIT election terminates. The entity is taxed as a regular C-corporation starting in the failure year and in every year after, unless it re-elects.¹

After termination or voluntary revocation, the entity generally cannot re-elect REIT status until the fifth taxable year beginning after the year the termination took effect.¹ That means at least five years of double taxation: the entity pays corporate tax, and shareholders pay individual tax on any dividends.

A narrow exception exists. If the termination wasn’t caused by willful neglect, the REIT timely filed its return for the failure year without fraud, and the failure was due to reasonable cause, the five-year waiting period doesn’t apply.¹ Meeting this standard after the income-test cure has already failed is a hard argument, because the cure required the same reasonable cause showing.

The 90 Percent Distribution Requirement Is Separate

Not technically part of the income tests, but close enough that missing it would be a real gap. A REIT has to distribute at least 90% of its taxable income (with certain adjustments) as dividends each year.³ Failing this requirement independently jeopardizes REIT status regardless of whether the income tests are satisfied. A REIT that passes both income tests but retains too much taxable income for reinvestment or reserves can lose its status just as surely as one earning the wrong kind of income.

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
eCFR. 26 CFR 1.857-5 – Net Income and Loss from Prohibited Transactions
3
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries