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?

Why Are Mortgage REITs Sensitive to Interest Rates?

A mortgage REIT earns interest on mortgages and mortgage-backed securities (MBS). It often buys those assets with borrowed money. Its profit is the spread: the interest it earns on its assets minus the interest it pays on its borrowing. Rising interest rates hurt a mortgage REIT in two ways:

• Asset values fall. Existing mortgages and MBS pay fixed interest. When market rates rise, new investors can get more interest elsewhere, so they pay less for the older, lower-paying assets. The REIT's holdings lose market value.
• The spread narrows. The REIT's borrowing costs can rise faster than the income from the assets it already owns. The gap between what it earns and what it pays shrinks.

An equity REIT earns rent from properties it owns, so it has less direct exposure to this lender's squeeze. That is why a question about rising rates and a REIT usually points to the mortgage REIT.

Exam Tip: Gotchas

• Higher rates do not help a mortgage REIT. New mortgages may pay more, but that income does not automatically cover higher borrowing costs, and the older fixed-rate assets still lose value.
• Fixed cash flows do not protect market value. The payments on an existing MBS stay the same, but the price an investor will pay for them falls when market rates rise.
• The distribution requirement does not force asset sales when rates rise. A REIT must distribute at least 90% of its taxable income to keep its tax treatment. That test looks at income, not at asset values or interest rates.

What Must a REIT Do to Qualify for Its Tax Treatment?

REITs receive a dividends-paid deduction if they meet the Internal Revenue Code (IRC) requirements for a REIT. A qualifying REIT invests mostly in real estate, earns most of its income from real estate-related sources, and distributes most of its taxable income to shareholders each year.

Exam Tip: Gotchas

• 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.
• Income is taxed once, but losses do not pass through. The dividends-paid deduction removes the REIT's own tax on distributed income. It does not turn the REIT into an S corporation, partnership, or MLP. Shareholders get Form 1099-DIV, not Schedule K-1, and a REIT loss stays at the REIT level.

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 most of its 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
• Dividends-paid deduction if IRC requirements are met, which avoids corporate tax on distributed income
• Losses stay at the REIT level and do not pass through to shareholders
• REIT dividends are generally taxed as ordinary income (not qualified dividends) for the portion that represents ordinary REIT income

Exam Tip: Gotchas

• REIT dividends representing ordinary REIT income are taxed as ordinary income, not qualified dividends. Candidates who assume "dividend = 15%/20% qualified rate" will miss this. The REIT deducts what it distributes, so that income was never taxed at the corporate level, and the IRS taxes that portion 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.

What Should You Check on Exam Day?

• Can you name the three REIT types (equity, mortgage, hybrid) and their income source, and explain why rising rates hurt a mortgage REIT (lower asset values, narrower spread over borrowing costs) more directly than an equity REIT?
• Can you describe the REIT qualification requirements in plain terms: mostly real estate assets, mostly real estate income, and paying out most taxable income to shareholders?
• Do you remember that a REIT loss stays at the REIT level, and shareholders receive Form 1099-DIV, not Schedule K-1?
• Do you remember that REIT dividends are generally taxed as ordinary income, not at the qualified-dividend rate, except for the portion the REIT designates as a capital gain dividend?
• Can you match a fact pattern (high fees, no secondary market, appraised pricing) to a non-traded REIT versus an exchange-traded REIT?