What Is a Taxable REIT Subsidiary (TRS)? Rules and 20% Cap

A taxable REIT subsidiary is a regular C corporation owned by a real estate investment trust that carries out the active business activities a REIT cannot perform directly without jeopardizing its pass-through tax status. The subsidiary pays the standard 21% federal corporate income tax on its own earnings, and any state corporate tax that applies. In exchange, the parent REIT keeps its rental and mortgage income clean under the tests it has to pass every year to remain a REIT.

The structure exists because REITs live under tight rules about what they can earn and how they can earn it. A taxable REIT subsidiary, usually called a TRS, is the pressure valve.

Why a REIT Needs a Separate Corporation

A REIT has to satisfy two annual gross income tests. At least 75% of its gross income must come from core real estate sources: rents from real property, mortgage interest, gains from selling real estate that isn’t dealer property, and dividends from other REITs. A second, broader test requires that at least 95% of its gross income come from those same sources plus dividends, interest, and gains from securities.¹ Income from running a business, charging tenants for non-customary services, or flipping properties fits neither test. Without a separate entity to absorb that income, the REIT would fail to qualify.

Impermissible Tenant Service Income

Basic building services like common-area maintenance and trash removal don’t threaten rent qualification. Non-customary services do. Staffing a concierge desk, running a fitness center, or offering specialized janitorial work beyond what a typical building provides can taint the rent. If the service income from a property exceeds 1% of all income from that property for the year, the entire service income for that property is reclassified as impermissible tenant service income and stops counting as qualifying rent.²

Routing the service through a TRS solves this. When the TRS provides services to the REIT’s tenants, those services are treated as if the REIT never provided them, so the rent stays qualifying.³ The TRS reports the service revenue on its own return and pays corporate tax on the profit.

The Prohibited Transaction Tax

A REIT that sells property held primarily for sale to customers in the ordinary course of business owes a 100% tax on the net income from that sale. Safe harbors exist, but they are narrow.⁴ A TRS avoids the problem entirely. It can buy land, build on it, and sell the finished product as a dealer, paying regular 21% corporate tax on the gain instead.⁵ For any REIT with a development pipeline, that math makes a TRS essential.

What a TRS Typically Does

In practice, TRS entities appear wherever a REIT’s business touches something more active than collecting rent.

Hotel and lodging operations. A REIT can own a hotel, but a TRS typically leases it from the REIT and hires an eligible independent contractor to run day-to-day operations. The TRS itself cannot directly operate or manage a lodging or health care facility.⁶
Health care facilities. The same eligible independent contractor requirement applies. REIT owns the building, TRS leases it, third-party operator runs it.
Non-customary tenant services. Package handling, specialized security, conference-room booking, and similar amenities can generate revenue through the TRS without contaminating the REIT’s rental income.
Property development and sales. When the strategy involves building and selling rather than holding long-term, the TRS handles the dealer activity and pays ordinary corporate tax on the profits.
Third-party property management. If the REIT’s management team also manages buildings the REIT doesn’t own, those management fees are non-qualifying income, so a TRS collects them.

How a TRS Is Created

Formation is straightforward on paper. The REIT and a corporation it owns stock in file IRS Form 8875, jointly electing to treat that corporation as a taxable REIT subsidiary.⁷ The REIT must directly or indirectly own stock in the corporation, but third parties can also hold shares. Once made, the election is irrevocable unless both entities agree to revoke it, and neither the election nor a revocation requires IRS permission.⁶

One rule surprises people. If an existing TRS of a REIT owns more than 35% of the voting power or total value of another corporation’s securities, that second corporation automatically becomes a TRS of the same REIT, without any election filed.⁶ The rule prevents a REIT from burying non-qualifying activities in a chain of subsidiaries that technically never elected TRS status.

The 20% Asset Cap

A REIT cannot park unlimited value in its TRS entities. The securities of all TRSs combined cannot exceed 20% of the total value of the REIT’s assets, measured at fair market value.⁸ This is the main structural restraint keeping a REIT primarily a passive real estate owner rather than an operating company in a REIT wrapper.

Monitoring the limit is harder than it sounds. As property values shift, so does the denominator, and a booming TRS or a dip in real estate values can push the ratio past 20% without any new investment. Asset tests are measured at the close of each calendar quarter, so most REITs track the ratio quarterly.

If a REIT breaches the cap, it can preserve its REIT status when the failure was due to reasonable cause and not willful neglect. The REIT identifies the problem, describes the offending assets in a schedule filed with the IRS, and disposes of the excess (or otherwise comes back into compliance) within six months. Even with the cure, the REIT owes a tax equal to the greater of $50,000 or an amount tied to net income from the non-compliant assets.⁶ A separate de minimis exception covers failures where the excess assets are worth less than the lesser of 1% of total REIT assets or $10 million.

Arm’s-Length Pricing and the 100% Excise Tax

Once a REIT and its TRS start transacting with each other, the temptation to shift income and deductions across the corporate boundary is obvious. Congress answered with a 100% excise tax on four categories of abuse: redetermined rents, redetermined deductions, excess interest, and redetermined TRS service income.⁹

The most common scenario: a REIT owns a building and leases it to its TRS, which operates a hotel there. If the IRS determines under transfer-pricing rules that the rent should be adjusted downward to reflect the economic reality of the TRS providing services to tenants, the gap between actual rent and the arm’s-length rent is redetermined rent. The REIT owes 100% of that gap as an excise tax, on top of the regular tax already due. The same logic applies if the TRS overpays interest on a loan from the REIT or if deductions get shifted onto the TRS.

Several exceptions keep legitimate arrangements clear of the 100% tax. If service income from a property stays within the 1% impermissible-tenant-service-income threshold, the excise tax doesn’t apply to those amounts. If the TRS charges unrelated third parties similar fees for similar services and charges to REIT tenants are substantially comparable, the tax doesn’t kick in. If the service is billed separately from rent and tenants who don’t use it pay substantially comparable rent to those who do, the arrangement passes. And if the TRS’s gross income from a service equals at least 150% of its direct cost to provide it, the excise tax doesn’t apply.⁹

The exceptions give REITs real room to operate, but the documentation burden is significant. Transfer-pricing studies, comparable-fee analyses, and cost-plus calculations need to be ready for each intercompany arrangement. Getting this wrong doesn’t just mean paying the tax that should have been paid. It means paying that tax plus a 100% penalty on top.

How TRS Income Flows Back to the REIT

The TRS files its own corporate return and pays 21% federal corporate tax on its net income, plus any applicable state corporate tax.⁵ State rates range roughly from 2% to nearly 12% depending on where the TRS operates, so the combined tax bite can approach a third of TRS profits before any money reaches the parent.

What’s left goes to the REIT as a dividend, and the way that dividend interacts with the two income tests matters. TRS dividends count as qualifying income for the 95% test, because that test includes dividends from any source. They do not qualify under the stricter 75% test, which is limited to rents from real property, mortgage interest, gains from real estate sales, and dividends from other REITs.¹ Every dollar of TRS dividends dilutes the 75% ratio. Combined with the 20% asset cap, this creates a natural ceiling on how large a role the TRS can play in the overall enterprise.

The double taxation is real. The TRS earns income and pays corporate tax. The after-tax profit goes to the REIT as a dividend. The REIT distributes at least 90% of its taxable income (including that dividend) to shareholders, who pay tax again at their individual rates.¹⁰ Income moving through the TRS path is taxed twice before it reaches investors, compared with once for rent the REIT collects directly. The cost is worth bearing only when the alternative, losing REIT status or paying the 100% prohibited transaction tax, is worse.

What Happens When the Rules Are Broken

Consequences depend on which rule is violated. A REIT that fails the 75% or 95% gross income test doesn’t automatically lose its status if the failure was due to reasonable cause, but it owes a penalty tax based on the non-qualifying income that caused the failure.¹⁰

For asset-test violations, the cure mechanism gives six months to fix a breach of the 20% TRS cap, and the minimum $50,000 penalty still applies to good-faith mistakes.⁶ If the failure isn’t cured in time or wasn’t due to reasonable cause, the entity loses its REIT election entirely and cannot re-elect for five years. Losing REIT status means the entire entity pays corporate tax on all its income, a catastrophic outcome for shareholders who invested expecting pass-through treatment.

The 100% excise tax on redetermined items operates independently. It doesn’t threaten REIT status, but it can wipe out the economic benefit of the TRS arrangement in a single audit. A REIT that charges below-market rent to its TRS and gets caught doesn’t just owe the tax it should have collected. It owes the full redetermined amount as a penalty, which makes non-compliance far more expensive than pricing the transaction correctly from the start.

1
Office of the Law Revision Counsel. 26 USC 856 – Definition of Real Estate Investment Trust
2
Legal Information Institute. 26 U.S. Code 856 – Impermissible Tenant Service Income
3
Internal Revenue Service. Revenue Ruling 2002-38
4
Office of the Law Revision Counsel. 26 U.S. Code 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
5
Office of the Law Revision Counsel. 26 U.S. Code 11 – Tax Imposed
6
Office of the Law Revision Counsel. 26 U.S. Code 856 – Definition of Real Estate Investment Trust
7
Internal Revenue Service. IRS Form 8875 – Taxable REIT Subsidiary Election
8
Internal Revenue Service. Taxable REIT Subsidiaries Analysis of the First Year’s Returns Tax Year 2001
9
Office of the Law Revision Counsel. 26 USC 857 – Taxation of Real Estate Investment Trusts and Their Beneficiaries
10
U.S. Securities and Exchange Commission. Investor Bulletin: Real Estate Investment Trusts