Real Estate Investment Trusts (REITs)
REITs pool capital to invest in real estate or real estate-related assets (mortgages). They are not registered under the Investment Company Act of 1940. Instead, they are regulated under the Internal Revenue Code.
Types of REITs
| Type | Invests In | Income Source |
|---|---|---|
| Equity REIT | Owns and operates properties | Rental income |
| Mortgage REIT | Real estate loans/mortgage-backed securities | Interest income |
| Hybrid REIT | Both properties and mortgages | Rent + interest |
REIT Qualification Requirements (Internal Revenue Code Section 856)
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")
Memory Aid: 75/75/95/90 + 100 shareholders + 5/50 rule.
Think of it this way: Congress created REITs to let everyday investors own real estate without double taxation. The REIT itself pays no corporate tax as long as it pushes at least 90% of taxable income out to shareholders, who then pay tax on the distributions. One layer of tax instead of two.
REIT Characteristics
- 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.
Traded vs Non-Traded REITs
| Feature | Exchange-Traded REIT | Non-Traded REIT |
|---|---|---|
| Liquidity | High - trades on exchange like stock | Very low - no secondary market |
| Pricing | Market price, continuous | Appraised value, periodic |
| Transparency | SEC reporting, public pricing | Less transparent |
| Minimum investment | Price of one share | Often $1,000-$5,000 |
| Fees | Low (like stocks) | High upfront fees (may be 10-15%) |
| Redemption | Sell on exchange anytime | Limited share repurchase programs (if any) |
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.