REIT Qualifications: Ownership, Asset, Income, and Distribution Tests

To qualify as a REIT, a company must meet a set of Internal Revenue Code Section 856 requirements covering how it’s organized, who owns it, what it holds, where its income comes from, and how much it pays out. The REIT qualifications work as a package: if the entity distributes at least 90 percent of its taxable income and clears the asset and income tests, it avoids corporate-level tax on the distributed portion. Miss any test without a timely cure, and the company is taxed like an ordinary C corporation.¹

Entity Form and the Election

A REIT has to be an entity that would otherwise be taxable as a domestic corporation. Traditional corporations, limited partnerships, LLCs, and business trusts all qualify, provided they’re formed in one of the 50 states or the District of Columbia. At least one director or trustee must manage the entity, and the shares or certificates of beneficial interest must be freely transferable.¹

The election itself is made by filing IRS Form 1120-REIT with the company’s tax return. Because that return isn’t due until March, the election happens after the close of the first taxable year as a REIT. The entity must use a calendar year. Once made, REIT status continues automatically until the company revokes it or fails a qualification test.²

Ownership Requirements

The 100-Shareholder Rule

Beginning with its second taxable year, a REIT must have at least 100 shareholders. The rule is meant to keep a handful of investors from using the structure as a private vehicle for pass-through treatment Congress designed for broadly held pools.³

The 5/50 Rule

Even with 100 shareholders on the books, five or fewer individuals cannot own more than 50 percent of the outstanding shares during the last half of any taxable year. The IRS reads “individuals” broadly, sweeping in certain trusts and private foundations, so routing ownership through related entities doesn’t defeat the rule as easily as it might look.³

Shareholder Records and Demand Letters

Meeting these ownership tests requires proof, not guesswork. Treasury Regulation Section 1.857-8 requires every REIT to maintain records of who owns its stock and to send annual demand letters to certain shareholders asking for written confirmation of ownership. The letters must go out within 30 days after the close of the tax year. Who receives them depends on the size of the shareholder base:

REITs with 2,000 or more shareholders of record demand confirmation from each holder of 5 percent or more.
REITs with 201 to 1,999 shareholders demand from each holder of 1 percent or more.
REITs with 200 or fewer shareholders demand from each holder of 0.5 percent or more.

Skipping the process carries a $25,000 penalty, or $50,000 if the failure is intentional. Reasonable cause can waive it.

Asset Tests

The IRS looks at what a REIT owns at the close of each calendar quarter. The point is to confirm the portfolio is genuinely anchored in real estate rather than functioning as a shell for other investments.

The 75 Percent Asset Test

At least 75 percent of a REIT’s total assets must consist of real estate assets, cash, cash items, and government securities. Real estate assets include land, buildings, mortgages secured by real property, and shares in other qualified REITs.¹

The 5 Percent and 10 Percent Concentration Limits

For assets outside the real estate bucket, two limits apply. No more than 5 percent of total assets can be invested in the securities of any single issuer, and the REIT cannot hold securities representing more than 10 percent of either the voting power or the total value of any one issuer’s outstanding securities. These rules keep a REIT from quietly turning into a holding company for a non-real-estate business.¹

The 30-Day Cure

Tripping an asset test at quarter-end doesn’t automatically end REIT status. A savings provision lets the REIT dispose of the nonqualifying assets within 30 days of the quarter’s close and avoid the failure entirely. No reasonable cause showing is required, and no penalty attaches. That makes the 30-day window the first line of defense when market movements or a single acquisition push portfolio percentages out of line.

Income Tests

Two annual tests police where the money comes from.

The 75 Percent Gross Income Test

At least 75 percent of gross income must come from real estate sources: rents from real property, mortgage interest, gains from selling real estate, dividends from other REITs, and refunds of real property taxes.¹

The 95 Percent Gross Income Test

The broader test requires 95 percent of gross income to come from the real estate sources above plus passive income like dividends, interest, and gains from selling securities. Only 5 percent can come from anything else. Both tests exclude income from prohibited transactions.¹

Failing an Income Test

An income test failure isn’t automatically fatal. If the failure was due to reasonable cause rather than willful neglect and the REIT discloses the problem to the IRS, status is preserved but a penalty tax applies. That tax equals the greater of the 95 percent or 75 percent shortfall, multiplied by a fraction that reflects the REIT’s profitability. Documenting reasonable cause is the difference between paying a tax and losing the election.

The 90 Percent Distribution Requirement

Every year, a REIT must distribute at least 90 percent of its taxable income to shareholders as dividends. Anything retained is taxed at regular corporate rates, so the incentive to pay out runs in the same direction as the rule.³

Ninety percent keeps the election alive but doesn’t avoid the 4 percent excise tax under IRC Section 4981. That excise applies to the gap between what the REIT was required to distribute for the calendar year (roughly 85 percent of ordinary income plus 95 percent of capital gain net income) and what it actually distributed. It’s due by March 15 of the following year.⁴

A REIT that misses the 90 percent floor outright risks losing its status entirely and being taxed as a C corporation on all of its income.

The Dealer Property Rule

A REIT is treated as an investor, not a dealer. If the IRS characterizes a sale as dealer activity, a 100 percent tax on the gain applies. A statutory safe harbor keeps ordinary dispositions out of that zone: the property must have been held for at least two years, and capital expenditures during the two years before sale cannot exceed 30 percent of the sale price. Additional safe harbor conditions cap the number of property sales a REIT can make in a year. Meeting the thresholds creates a strong presumption that the transaction isn’t dealer activity.

Using a Taxable REIT Subsidiary

Some income a REIT wants to earn wouldn’t clear the gross income tests. Management fees, hotel operations, and certain tenant services fall into that category. Rather than jeopardize the parent’s qualification, the REIT can run those activities through a taxable REIT subsidiary, a corporation owned directly or indirectly by the REIT that has jointly elected TRS treatment. The subsidiary pays corporate income tax at 21 percent on its earnings, and its activities don’t contaminate the parent.

The trade-off is a cap: TRS securities cannot exceed 20 percent of the REIT’s total assets at the close of any quarter. That limit keeps a REIT from parking most of its business in a taxable subsidiary while claiming pass-through treatment on what’s left. Acquisitions that shift the asset mix can move a REIT close to the ceiling quickly, so the 20 percent line needs regular monitoring.

What Happens If You Lose REIT Status

A REIT that fails a qualification test and can’t cure the failure loses its election. The immediate hit is full corporate-level tax on all income, wiping out the pass-through benefit. The longer hit is a five-year lockout: the company generally can’t re-elect REIT status for the five taxable years after the year of disqualification, unless the IRS grants relief based on reasonable cause and no willful neglect.

That five-year door is why serious REITs put money into compliance: quarterly asset test tracking, the shareholder demand letter cycle, income sourcing reviews, and pre-clearance for property sales. Slips caught inside the cure windows are survivable. Repeated neglect isn’t.

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
Internal Revenue Service. Instructions for Form 1120-REIT
3
U.S. Securities and Exchange Commission. Investor Bulletin: Real Estate Investment Trusts (REITs)
4
Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts