REIT Requirements: Tests, Distributions, and Penalties

REIT requirements are the ongoing tests in the Internal Revenue Code that a real estate investment trust must satisfy to keep its pass-through tax treatment: rules about how it is organized, who owns it, where its income comes from, what its balance sheet looks like, and how much of its earnings it pays out each year. Miss any one of them and the entity is taxed as an ordinary C corporation for the year, and in the worst case it cannot re-elect REIT status for five years.

The tests fall into four buckets, and every one is measured annually or quarterly. What follows walks through each, plus the penalty and relief regime that decides what happens when a REIT slips.

Organizational and Ownership Rules

A REIT has to be a corporation, trust, or association that would otherwise be taxed as a domestic corporation, managed by at least one director or trustee, with beneficial ownership represented by transferable shares or certificates. Banks and insurance companies are excluded outright.¹

Two ownership tests then keep the REIT from operating as a private investment vehicle:

At least 100 people must hold beneficial ownership. This requirement does not apply in the first tax year, but after that it must be met for at least 335 days of a 12-month tax year (or a proportional part of a shorter year).
The REIT cannot be closely held. During the last half of the tax year, five or fewer individuals cannot own more than 50% of outstanding shares. Constructive ownership counts, applying the personal holding company attribution rules.²

To police these rules, Treasury regulations make every REIT send annual demand letters to significant shareholders within 30 days after the close of the tax year, requesting written disclosure of their actual and constructive ownership. Failing to do so, or failing to keep the resulting records, carries a $25,000 penalty ($50,000 if intentional), waivable for reasonable cause.

Gross Income Tests

Two income-source thresholds keep the entity focused on real estate rather than active business. Both are tested annually on gross income, excluding income from prohibited transactions.

The 75% Test

At least 75% of gross income has to come from a narrow list of real-estate sources: rents from real property, interest on obligations secured by real property, gains from selling real estate that is not dealer property, dividends from other qualified REITs, income from foreclosure property, and certain loan commitment fees.¹

The 95% Test

At least 95% must come from the 75% categories plus a wider set of passive investment income: dividends from non-REIT stocks, interest from non-real-estate sources, and gains on securities sales. In practical terms, no more than 5% of gross income can come from active operations or other nonqualifying sources.

Rents From Real Property

Rental income is the core of most equity REITs, and the statute is picky about what counts. Three kinds of rent are pulled out of the definition:

Rent tied to a tenant’s net income or profits. A percentage-of-gross-receipts lease is fine; a percentage-of-net-profits lease is not.
Rent from a tenant in which the REIT owns 10% or more (measured by vote or value for corporations, or by asset or profit interest for other entities).
Impermissible tenant service income. If the REIT directly furnishes services to tenants that go beyond what is customary for the property type, the service income is disqualified. Worse, if that impermissible income at a single property exceeds 1% of all amounts received from that property for the year, the entire rental stream from that property is treated as nonqualifying.¹

Hotel and healthcare REITs work around the third rule by providing non-customary services through an independent contractor from whom the REIT earns no income, or through a taxable REIT subsidiary. Services routed that way are not attributed to the REIT, and the rent stays qualified.

Income from qualifying hedging transactions is excluded entirely from both tests. It does not help satisfy them and cannot cause a failure, provided the hedge is properly identified and does not exceed the notional principal of the underlying debt used to acquire real estate assets.

Asset Tests

Portfolio composition is tested at the close of each calendar quarter.

75% in Real Estate

At least 75% of total assets must consist of real estate assets, cash, and government securities. Real estate assets include real property, mortgage loans, interests in other REITs, and certain mortgage-backed securities.¹

Diversification of the Other 25%

Assets outside the 75% bucket face three concentration limits, tested issuer by issuer:

5% asset test: securities of any single issuer cannot exceed 5% of total assets.
10% vote test: the REIT cannot own more than 10% of any single issuer’s outstanding voting securities.
10% value test: the REIT cannot own securities whose value exceeds 10% of the total value of any single issuer’s outstanding securities.

These limits do not reach government securities, shares of other qualified REITs, or securities already counted in the 75% bucket. They also do not apply to interests in a taxable REIT subsidiary, though TRS securities in total cannot exceed 20% of the REIT’s total assets.

30-Day Cure Period

A REIT that finds itself offside at quarter-end has 30 days after the close of that quarter to fix the problem, whether by selling the offending securities or acquiring additional qualifying assets to shift the ratios. A completed cure inside the window carries no penalty. This grace period has saved a number of REITs from failures triggered by market moves or unexpected revaluations.

Distribution Requirements

The distribution rule is the mechanism that actually makes REITs pass-through vehicles. The REIT’s dividends-paid deduction for the year must equal or exceed 90% of REIT taxable income, calculated before that deduction and excluding net capital gain. Anything retained (up to 10%) is taxed at regular corporate rates. Miss the 90% threshold and the REIT provisions do not apply for the year at all, effectively turning the entity into a taxable corporation for that year.³

The 4% Excise Tax

A separate 4% excise tax under Section 4981 applies to any shortfall between the calendar-year required distribution and the amount actually paid. The required distribution here is 85% of ordinary income plus 95% of net capital gains, with any prior-year shortfall added on top. The excise tax is due by March 15 of the following year.⁴

The two thresholds run independently. Section 857’s 90% test governs whether the REIT keeps its status. Section 4981’s 85%/95% test governs whether it owes the excise tax. Year-end planning has to clear both.

Spillover Dividends

A REIT can declare a dividend in the current year, pay it early in the following year, and still count it toward the earlier year’s distribution requirement, so long as it is declared before the tax return filing deadline and paid within the next 12 months. This is the standard tool for smoothing cash flow around year-end.

Prohibited Transactions

Selling property that the REIT held primarily for sale to customers in the ordinary course of business triggers a 100% tax on the net income from the sale. The rule stops REITs from operating as dealers, flipping property for short-term profit.³

A safe harbor removes the doubt when all of the following are true:

The REIT held the property at least two years and used it to produce rental income during that time.
Capital expenditures during the two years before the sale did not exceed 30% of the net selling price.
The REIT sold no more than seven properties during the tax year, or the total adjusted basis (or fair market value) of properties sold did not exceed 10% of the REIT’s aggregate assets at the start of the year.
If the seven-property limit is exceeded, substantially all marketing and development work was handled by an independent contractor or a taxable REIT subsidiary.

Falling outside the safe harbor is not automatic disqualification. The question becomes a facts-and-circumstances analysis of whether the REIT was really acting as a dealer.

What Happens if a REIT Fails a Test

Losing REIT status is the worst outcome, but the code offers graduated relief for most failures.

For an income-test miss (75% or 95%), the REIT keeps its status if the failure was due to reasonable cause rather than willful neglect. It has to disclose the failure on its return and pay a penalty tax equal to the nonqualifying income multiplied by a fraction that approximates the REIT’s overall profitability.

For an asset-test miss beyond the 30-day cure period, a de minimis failure of the 5% or 10% tests carries no penalty. Larger failures can be corrected with disclosure and a penalty equal to the greater of $50,000 or the net income from the offending assets multiplied by the highest corporate rate.

For failures of the other structural rules (the 100-shareholder test, the closely held test, transferable shares, board of directors), reasonable cause plus a flat $50,000 penalty per violation preserves the REIT’s status.

The Five-Year Lockout

If none of the savings provisions apply and the REIT actually loses its status, the entity and any successor cannot re-elect REIT treatment until the fifth taxable year after the termination. The lockout does not apply if the REIT can show the failure resulted from reasonable cause, the return was timely filed, and no fraud was involved.¹

Reasonable cause in any of these contexts usually means documented compliance procedures, regular reviews, and reliance on tax counsel for ambiguous calls. Retroactive claims of good faith without a paper trail rarely hold up.

How Shareholders Are Taxed on What Comes Out

The point of meeting all the tests above is that distributed income is not taxed at the entity level. Shareholders pick up the tax, reported each year on Form 1099-DIV, with distributions split into three categories.⁵

Ordinary income dividends make up the bulk of most REIT distributions and are taxed at your marginal rate. Non-corporate taxpayers can deduct up to 20% of qualified REIT dividends under Section 199A, which effectively lowers the top rate on that income. The One Big Beautiful Bill Act, signed in 2025, made this deduction permanent.⁶

Capital gain dividends, paid out of gains on property held more than a year, are taxed at long-term capital gains rates.

Return-of-capital distributions exceed the REIT’s current and accumulated earnings and profits. They are not taxed on receipt; instead they reduce your basis in the shares. Once basis reaches zero, any further return-of-capital distribution is taxed as a capital gain.

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
U.S. Securities and Exchange Commission. Investor Bulletin – Real Estate Investment Trusts (REITs)
3
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
4
Office of the Law Revision Counsel. 26 USC 4981 – Excise Tax on Undistributed Income of Real Estate Investment Trusts
5
Internal Revenue Service. Form 1099-DIV – Dividends and Distributions
6
Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income