Real Estate Investment Trusts (REITs)
REITs provide a way for investors to access income-producing real estate without directly buying, managing, or financing properties. The Series 7 exam tests their structure, qualification rules, and tax treatment.
REIT Structure
A Real Estate Investment Trust (REIT) is a corporation, trust, or association that pools investor capital to own or finance income-producing real estate.
- REITs issue a finite number of transferable shares
- In the primary market, shares are distributed at IPO price (similar to closed-end funds)
- Publicly traded REITs trade on exchanges in the secondary market and may trade at premiums or discounts to net asset value (NAV)
REIT Categories by Liquidity
| Category | SEC Registration | Exchange-Traded | Liquidity |
|---|---|---|---|
| Publicly traded REIT | Yes | Yes | High - trades on exchanges |
| Non-traded REIT | Yes | No | Low - limited redemption options |
| Private REIT | No (exempt) | No | Very low - accredited/institutional investors only |
Key distinction: REITs are not investment companies under the Investment Company Act of 1940. They are governed by the Internal Revenue Code (IRC Sections 856-858).
Exam Tip: Gotchas
- Non-traded REITs are SEC-registered but NOT exchange-traded. They file with the SEC like publicly traded REITs, but shares do not trade on an exchange, making them illiquid with limited redemption options.
- REITs are not investment companies under the 1940 Act, even though they pool investor capital. They follow IRC rules instead.
REIT Qualification Requirements (IRC Section 856)
To receive favorable tax treatment, a REIT must satisfy several tests simultaneously:
| Test | Requirement |
|---|---|
| 75% income test | At least 75% of gross income must come from real estate sources (rents, mortgage interest, real property sales, REIT dividends) |
| 95% income test | At least 95% of gross income must come from qualifying real estate sources plus dividends, interest, and securities gains |
| 75% asset test | At least 75% of total assets must be invested in real estate, cash, or government securities |
| 90% distribution rule | Must distribute at least 90% of taxable income to shareholders annually |
| 100 shareholder rule | Must have at least 100 shareholders (applies from the second taxable year onward, for at least 335 days of a 12-month tax year) |
| 5/50 rule | No more than 50% of outstanding shares may be owned by 5 or fewer individuals during the last half of the tax year |
Tax benefit: If a REIT meets the distribution requirement, it receives a dividends-paid deduction and avoids corporate-level taxation on distributed income.
Consequence of failure: Losing any qualification test may result in loss of REIT status entirely.
Exam Tip: Gotchas
The 90% distribution rule is what allows the REIT to avoid corporate-level tax - it does NOT mean 90% of distributions are tax-free to shareholders. Shareholders still owe tax on what they receive.
Types of REITs
| Type | Invests In | Primary Income Source |
|---|---|---|
| Equity REIT | Owns and operates income-producing real estate (office buildings, apartments, retail, industrial) | Rental income and property appreciation |
| Mortgage REIT | Provides financing by purchasing or originating mortgages and mortgage-backed securities | Interest income from mortgage loans |
| Hybrid REIT | Combination of equity and mortgage strategies | Both rental income and mortgage interest |
- Equity REITs are the most common type
- Mortgage REITs are especially sensitive to interest rate risk because they profit from the spread between borrowing costs and mortgage yields
- Interest rates up → borrowing costs rise → mortgage REIT profitability squeezed
- Hybrid REITs aim to diversify income streams but are less common in practice
Think of it this way: Equity REITs are landlords (they collect rent). Mortgage REITs are lenders (they collect interest). When rates rise, lenders get squeezed because their borrowing costs jump but their existing loans are locked in at lower rates.
Exam Tip: Gotchas
- Mortgage REITs carry the most interest rate risk among REIT types. Rising rates compress the spread between what they earn on mortgages and what they pay to borrow.
- Equity REITs are affected by interest rates too, but their primary risk is real estate market conditions (vacancies, rental rates).
REIT Tax Treatment
REIT dividends are taxed differently depending on the type of distribution:
| Distribution Type | Tax Treatment to Shareholder |
|---|---|
| Ordinary dividends | Taxed as ordinary income - do NOT qualify for the lower qualified dividend rate |
| Capital gain distributions | Taxed at long-term capital gains rates |
| Return of capital | Not immediately taxable; reduces the shareholder's cost basis; taxed as capital gain when shares are sold |
- REITs issue Form 1099-DIV that classifies each distribution as ordinary dividends, capital gains, or return of capital
- Because REITs must distribute 90%+ of income, they retain little cash for growth
- Expansion is typically funded through additional share offerings or debt
Exam Tip: Gotchas
- REIT dividends are generally taxed as ordinary income, NOT at the lower qualified dividend rate. Candidates often confuse REIT dividends with qualified dividends from regular corporations.
- Return of capital distributions reduce your cost basis. They are not taxed when received, but they increase your taxable gain (or reduce your deductible loss) when you eventually sell the shares.