Real Estate Investment Trusts

REITs sit outside the Investment Company Act entirely, so do not reach for ICA rules (diversification tests, redemption deadlines) when a question describes one. Everything that governs a REIT's tax treatment comes from the IRC instead.

What Are the Types of REITs?

What Must a REIT Do to Qualify for Pass-Through Taxation?

REITs receive pass-through taxation if they meet these Internal Revenue Code (IRC) requirements:

• At least 75% of total assets must be in real estate, cash, or government securities
• At least 75% of gross income must come from real estate-related sources (rents, mortgage interest)
• At least 95% of gross income must come from passive sources (real estate income + dividends + interest)
• Must distribute at least 90% of taxable income to shareholders annually
• Must have at least 100 shareholders
• No more than 50% of shares held by 5 or fewer individuals (the "5/50 rule")

Exam Tip: Gotchas

• The 90% distribution test and the 95% income test are not the same number and answer different questions. The 95% figure is an income test: it measures where the REIT's gross income comes from (passive sources like rents, mortgage interest, dividends, and interest). The 90% figure is the distribution requirement: it measures where the REIT's income goes (how much of its taxable income it pays out to shareholders). Mixing them up is a common trap.
• Distributions to shareholders are generally taxed as ordinary income to the extent they represent ordinary REIT income, not capital gains, since the REIT itself paid no corporate tax on that income.

Think of it this way: Congress created REITs to let everyday investors own real estate without double taxation. A REIT that meets all the qualification tests above, including distributing at least 90% of taxable income, pays no corporate tax on the income it distributes; shareholders then pay tax on those distributions. One layer of tax instead of two.

What Other Characteristics Define a REIT?

• Structured as corporations or trusts
• NOT registered under the Investment Company Act of 1940 (ICA) (exempt); regulated under the IRC
• Pass-through taxation if IRC requirements are met
• REIT dividends are generally taxed as ordinary income (not qualified dividends) for the portion that represents ordinary REIT income

Exam Tip: Gotchas

• REIT dividends are taxed as ordinary income, not qualified dividends. Candidates who assume "dividend = 15%/20% qualified rate" will miss this. REITs pass through untaxed corporate income, so the IRS taxes it at the shareholder's full marginal rate.

How Do Traded and Non-Traded REITs Differ?

Exam Tip: Gotchas

• Non-traded REITs are ILLIQUID. The exam loves to test that non-traded REITs have limited redemption options, high fees, and lack of price transparency. An investor needing liquidity should NOT be in a non-traded REIT.
• REITs must distribute 90% of TAXABLE INCOME (not 90% of total income or cash flow). This is the most commonly tested REIT threshold.

What Should You Check on Exam Day?

• Can you name the three REIT types (equity, mortgage, hybrid) and their income source?
• Do you know all six qualification tests: 75% of assets, 75% and 95% of gross income, 90% distribution, 100-shareholder minimum, and the 5/50 rule?
• Can you separate the 95% income test from the 90% distribution requirement without swapping them?
• Do you remember that REIT dividends are generally taxed as ordinary income, not at the qualified-dividend rate?
• Can you match a fact pattern (high fees, no secondary market, appraised pricing) to a non-traded REIT versus an exchange-traded REIT?