How to Qualify as a REIT: Deciphering Eligibility Requirements

How to Qualify as a REIT: Deciphering Eligibility Requirements

June 19, 2023
Updated: (Optional) Published: 2/2/2023
Qualifying as a Real Estate Investment Trust for Preferential Tax Treatment

Navigating the elaborate maze of REIT eligibility requirements. The dos, don’ts, and select remedies.

In the world of REITs, not every real estate venture makes the cut. There is a set of rules, and eligibility requirements, that need to be met and continued to be met to qualify as a REIT. This article is about getting to the heart of those requirements. We'll dissect the specifics - the assets, the income, the shareholder structure - all the nuts and bolts that define a REIT. Let's delve into what it truly means to qualify as a REIT.

What is a REIT?

A Real Estate Investment Trust is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs provide investors of all types the opportunity to own valuable real estate, present the opportunity to access dividend-based income and total returns and help communities grow, thrive, and revitalize.

While typical real estate firms concentrate on selling properties once they are developed, a Real Estate Investment Trust differentiates itself by primarily acquiring real estate assets to be operated and managed as long-term investments within their portfolios. Learn about the benefits of a REIT to investors, developers, and operators, here.

“Today, U.S. REITs own nearly $4.5 trillion of gross real estate with public REITs owning $3 trillion in assets. U.S. listed REITs have an equity market capitalization of more than $1.3 trillion. In 2021, REITs paid an estimated $92.3 billion in dividends to shareholders.” [1]

REIT Structure and Stakeholders

The structure of a Real Estate Investment Trust revolves around the central principle of distributing a substantial part of its income to shareholders, thus avoiding corporate income tax. Typically, a REIT structure involves the following stakeholders, and its ecosystem works like this:

  • The REIT sponsor is typically the founding team or principles of the REIT, who either invested capital or contributed assets to the REIT.
  • A REIT is organized as a corporation or trust.
  • The REIT's Board of Directors oversees the operations and regulatory compliance requirements of a REIT.
  • A REIT's assets are primarily composed of real estate properties that are housed under a separate legal entity called an Operating Partnership. Other assets may include real estate-related securities, such as mortgages, or taxable REIT subsidiaries, which are essentially businesses that provide services - for example, landscaping - to the REIT for its real assets.
  • A REIT is typically the general partner to the Operating Partnership.
  • A REIT Advisor typically provides strategic advice, asset management, and administrative services. It is common for the advisor and general partner to be legally separate entities. In some cases, an advisor does not exist, in which case, the REIT is internally managed by its own management and board.
  • The Advisor is typically the general partner of the REIT and is contracted by the REIT.
Diagram showing the structure of Real Estate Investment Trusts.

REIT Eligibility Requirements

1. Entity and Organizational Requirements

Entity type

A REIT must be a legal entity, such as a corporation, trust, or association. If it's an LLC, it can choose to be treated as a corporation for tax purposes. To be recognized as a REIT, the entity must file an income tax return on Form 1120-REIT.

Organizational Requirements

The REIT’s management should be overseen by one or more trustees or directors.

2. Ownership Criteria

100 shareholder test

The "100 Shareholder Test" is aimed at maintaining a broad and diverse REIT ownership base. This rule mandates that, from the second taxable year onward, a REIT must be owned by at least 100 individuals for a minimum of 335 days within any standard 12-month taxable year. This requirement is proportionally adjusted for shorter tax periods.

It is important to note that the count of shareholders is based on who directly holds the REIT shares, that is, the recipient of Form 1099-DIV. Therefore, this test does not account for the concept of attribution. For example, if one Limited Liability Company, with 101 members, solely owns the REIT stock in the LLC's name, the LLC is counted as a single shareholder for the purposes of the 100 Shareholder Test. In such a case, despite the large number of members that own the LLC, the REIT would fail the test.

It is also worth noting that this rule encompasses all classes of shares. For instance, a REIT with just one common shareholder and 100 preferred shareholders would successfully pass the 100 Shareholder Test. Publicly traded REITs typically don't struggle with this rule due to the large number of investors they raise capital from. However, since private REITs used securities law exemptions to raise capital from larger institutional or accredited investors, private REITs often grapple with securing sufficient investors to qualify for this test.

5/50 Rule

From the second taxable year onwards, during the latter half of each tax year, no five individuals, directly or indirectly, can own more than 50% of the REIT's stock. Unlike the 100 shareholder test, attribution rules apply to the 5/50 rule. Therefore, when determining whether a REIT meets the 5/50 rule, the REIT must take into account the ownership of its shares by related parties, such as family members (brothers, sisters, spouses, lineal descendants) and business entities (corporations, trusts, LLCs, and other organization structures) that are owned by the same ultimate beneficial owner, also referred to as UBO.

Diagram explaining the 5/50 rule.
Diagram explaining the 5/50 rule (continued)

Transferable Shares or Certificates

From its inception, a REIT must issue shares or transferable certificates which are free from any restrictive legends. Certain exemptions apply to this rule including:

  1. Restrictions required by the SEC under the Securities Act of 1933
  2. Restrictions that would lead to a REIT violating its 100 shareholder test or 5/50 rule requirements, such as transfers that would lead to a transferee owning shares in excess of the permitted percentage of the REITs total stock.
  3. Restrictions on employee stock that is not fully vested
  4. Restrictions where the REIT's trustee(s) or director(s) perceives that a transfer or non-redemption of shares could compromise the entity's REIT status.

Annual Shareholder Demand Letter

In order to ensure that a REIT is in compliance with its ownership tests, and pursuant to Treas. Reg. Section 1.857-8, REITs are required to demand stock ownership information from certain shareholders within 30 days of the close of its taxable year. The demand letter must require the shareholders to confirm the following:

  1. Actual Ownership of Stock: Actual owner of a REIT's stock is the person who must declare the REIT dividends from the stock as income on their tax return. Most of the time, this person is the recorded shareholder of the REIT. However, there can be cases where the recorded shareholder is not the actual owner of the stock, and in these situations, the REIT's official record of stock ownership might not reflect who really owns the stock. Therefore, the REIT is required to ask for written statements from the recorded shareholders to reveal who the real owners of the stock are.
  2. The maximum number of shares that are owned by the shareholder at any time during the second half of the year, after factoring in the attribution rules discussed above.

Pursuant to Treas. Reg. Section 1.857-8(d), the letter must be sent to shareholders per the following REIT ownership standards.

  1. In the case of a REIT with 2,000 or more shareholders of record of its stock on any dividend record date, the shareholder letter must be sent to each record holder of 5 percent or more of the REITs stock; or
  2. In the case of a REIT with less than 2,000 and more than 200 shareholders of record of its stock on any dividend record date, the shareholder letter must be sent to each record holder of 1 percent or more of the REITs stock; or
  3. In the case of a REIT with 200 or less shareholders of record of its stock on any dividend record date, the shareholder letter must be sent to each record holder of one-half of 1 percent or more of the REITs stock.

A REIT must keep a record of shareholders that fail to comply with the demand letter. The demand letter must also notify the shareholders that if they fail to comply, they are liable to submit their tax return statements pursuant to Treas. Reg. Section 1.857-8(d).

2. Asset Requirements

A REIT must ensure that 75% of its total asset value at the end of each quarter of a taxable year is made up of qualifying assets. These assets can be real estate assets, government securities, or cash and cash items, including receivables.

Additional restrictions include:

  • Securities of taxable REIT subsidiaries (TRSs) should not exceed 20% of a REIT’s total assets.
  • No single issuer should account for more than 5% of its total assets, except for securities that qualify for the 75% test and securities of TRSs.
  • Securities should not make up more than 25% of a REIT’s total assets.
  • A REIT should not hold more than 10% of the outstanding value of the securities of any one issuer, except with respect to TRSs.

Certain services, such as special cleaning services, do not qualify as REIT income because they are performed on behalf of the tenant and are not inherently part of the rental of real property. A REIT can navigate this by establishing a Taxable REIT Subsidiary (TRS), which can perform these services without the same restrictions. However, a TRS is taxed on its net income as a regular corporation. You can learn more about TRS here.

Compliance with the asset test must be checked quarterly, and any non-compliance must be cured generally within a one-month period.

3. Income Conditions

A REIT must satisfy two income tests each taxable year.

The first is the 75% test: a minimum of 75% of a REIT’s gross income should come from real estate-related sources. This gross income can include:

  • Rents from real property.
  • Interest on obligations secured by mortgages on real property or interests in real property.
  • Capital Gains from the sale or other disposition of real property.
  • Dividends and gains from the sale or other disposition of other REITs.
  • Abatements and refunds of taxes on real property.
  • Income and gain derived from foreclosure property.
  • Amounts received or accrued as consideration for entering into agreements to make loans secured by mortgages on real property or interests in real property; or to purchase or lease real property.
  • Gain from the sale or other disposition of a real estate asset that is not a prohibited transaction.
  • Qualified temporary investment income.

The second is the 95% test: at least 95% of a REIT’s gross income must come from the sources described in the 75% test and from earnings from certain types of portfolio income such as interest, dividends, and gains from sales of securities. To ensure compliance, REITs may create a TRS to hold property or receive income that does not qualify under these tests.

In the context of these tests, rents can include more than just the basic rent. They can also include additional charges such as rental escalations, charges for taxes, and common-area maintenance charges. Rents that are calculated based on the gross receipts of a tenant may qualify. However, rents that are contingent on the profits of a tenant would not. In simpler terms, if the rent is tied to how well the tenant's business is doing, it wouldn't qualify under the REIT income test.

A REIT could face severe penalties if it fails to meet the requirements of the income tests - it could be taxed 100% on the income that doesn't qualify (also known as "bad income"), or it could lose its REIT status altogether. This would subject it to corporate income tax on all of its income, and its shareholders to double taxation. Therefore, REITS must analyze their income each year to ensure they meet the requirements. Typically, REITs review their income every quarter to identify any potential issues early on and to have sufficient time to address them before the close of its tax year.

4. Distribution Obligations

To retain its REIT status, a REIT is required to distribute at least 90% of its annual taxable income. As a REIT can deduct these dividends from its taxable income, hence, most REITs aim to distribute at least 100% of its taxable income to avoid entity-level tax.

Due to the large amount of depreciation expense usually incurred by equity REITs, and as depreciation is deductible from taxable income, the income distribution requirement is generally not an issue as long as a REIT has sufficient cash flow.

If a REIT finds itself under-distributed, i.e. it does not have sufficient cash flows to make a distribution, it can use several provisions that may help it meet the 90 percent distribution requirement:

  1. Consent dividends
  2. Declaration of dividends before the end of the taxable year, paid in a subsequent year
  3. Declaration and payment of dividends in the subsequent year
Consent dividends

A REIT may elect to report a consent dividend for the remaining excess taxable income, which is a dividend that is not actually paid to its shareholders but deemed paid for purposes of the distribution test (IRC Section 565). Consent dividends must be declared on a REIT's tax return and require additional reporting on Form 972 and Form 973. Since the shareholders are subject to taxation similar to that applies to the receipt of an actual cash distribution, all REIT shareholders will have to sign Form 972 for the consent dividend to be declared effective.

For a REIT's taxable income to be eligible for dividends paid deduction, the REIT dividends have to be distributed pro rata to the shareholder's ownership and without any preferential dividend distribution provisions within the same stock class. Therefore, if any shareholder does not consent on Form 972 and subsequently does not receive any distribution, then no amounts with regards to the consent dividends will contribute towards the dividends paid deduction within that stock class.

Declaration of dividends before the end of the taxable year, paid in a subsequent year:

If a REIT declares but not pays a dividend in October, November, or December of a taxable year, and instead the dividend is paid to the shareholders of record during the following year, the distribution may be treated as paid on Dec. 31 of the current year for purposes of meeting the 90% distribution requirement for the current year. These distributions are only deemed paid by Dec. 31 to the extent that the REIT’s earnings and profits for the year exceed actual distributions paid. From the shareholder's perspective, the distribution must be reported as income in the year the dividend is declared, even though the shareholder receives cash in the subsequent year. (IRC Section 857(b)(9))

Declaration and payment of dividends in the subsequent year

A REIT can elect to include a specific amount of distributions, declared and paid in the following year, as paid during the current taxable year, to meet its distribution requirement. This is permitted as long as the REIT declares a dividend before the due date of the filing of the REIT's tax return, including extensions, and the dividend is paid to the shareholders within 12 months of the REIT's tax year but no later than the date of the first regular dividend payment. Though this dividend contributes towards the REIT's dividends paid deduction of the prior year, from the shareholder's perspective, the dividend income is treated as received by the shareholder in the taxable year in which the distribution is made. (IRC Section 858) While this option helps a REIT cure its distribution requirements, it may cause the REIT to become subject to an excise tax for the prior tax year, and in an amount up to 4% of the distribution amount that is in excess of the required distribution.

State and Local Tax Issues

It's important to remember that while certain jurisdictions align their regulations with federal laws pertaining to REITs, others deviate significantly - a distinction most noticeable in the context of consent dividends. This could lead to a situation where a REIT, despite having no federal taxable income, has income tax liability at the state and local levels.

State-level adjustments can further complicate tax matters. Beyond income tax, some states also impose franchise, excise, or net worth taxes on REITs. As such, a thorough understanding of the tax landscape at all levels - federal, state, and local - is essential for successful REIT operations.

5. REIT Shareholder Requirements and Other Factors

Table explaining other eligibility requirements for Real Estate Investment Trusts in any tax year.

Please remember that these are broad guidelines. There may be additional requirements or exceptions that come into play under special circumstances. You can schedule a  free consultation with us to understand the specific requirements and exemptions applicable to your REIT venture.

What happens if a REIT fails to meet the Eligibility Requirements?

It may face significant penalties and consequences, which can include:

  1. Loss of REIT Status: The entity will be disqualified from its REIT status, and may be subject to up to a five-year prohibition period on re-election as a REIT.
  2. Taxation as a Corporation: The entity will be taxed as a C Corporation.
  3. Enhanced scrutiny from auditors, investors, and regulators: A failure to operate within the REIT rules can represent a "deficiency", a "significant deficiency" or a "material weakness" under applicable US Securities and Exchange Commission (SEC) and accounting standards, which in turn imposes enhanced scrutiny and sanctions from financial auditors, investors, and government regulators.

Given these severe repercussions, it is critical for a REIT to build robust compliance practices from inception.

How much does it cost to start a REIT?

Depending on the scale of operation, and geography, the cost of starting a REIT can vary widely. Barring property acquisition costs, setting up a REIT can cost anywhere between a few hundred thousand to a few million dollars, most of which is associated with the scale of the operation and the quality of third-party experts - legal, accounting, investor relations, and compliance - engaged to form the REIT. Feel free to reach out to us today to fully understand the startup costs of your REIT venture.

Convert your real estate company into a REIT

Transforming an existing real estate company into a REIT involves a series of steps. The conversion process can be complex: corporate restructuring, asset evaluation, stakeholder management, and registration with financial authorities. We have evaluated the merits of transitioning a real estate company into a REIT structure, through the lens of developers, owners, and operators, in our article here.

How CIEL Can Help

REITs are phenomenal but complex capital markets vehicles that are regulated by various agencies. Forming and operating a REIT requires meticulous planning, significant reorganization, and an unwavering commitment to aligning stakeholders, and navigating the complex regulatory landscape.

CIEL experts can help you decipher REITs and U.S. capital markets - from drafting and filing a registration statement or filing Form 1120-REIT to implementing corporate governance practices to preempting and mitigating for any regulatory or compliance risks.

About CIEL

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