A REIT, or Real Estate Investment Trust, is a corporation with special tax considerations that buys and manages real estate properties and mortgage loans. REITs offer many advantages to real estate investors. They offer individual investors the opportunity to own shares in a portfolio of real estate properties and publicly traded REITs offer liquidity in a similar manner that stocks do. There are also significant tax advantages when forming a REIT, if the entity meets certain conditions. If a REIT meets certain tax law requirements, the entity can deduct dividends that are paid out to shareholders as taxable income. This offers significant tax benefits to the REIT.
There are several ownership tests that a REIT must satisfy. A REIT needs to be formed as a corporation in the District of Columbia or one of the fifty states. The entity must be governed by trustees or a board of directors, and the shares must be transferable. Starting in the second taxable year of the REIT, the entity must have a minimum of 100 different shareholders and five or less individuals cannot own fifty percent or more of the REIT’s value during the second half of the taxable year.
There are also two income tests and some quarterly asset tests that a REIT must satisfy in order to ensure that a majority of the assets and income are from real estate. Seventy five percent of annual gross income must come from real estate sources such as interest on mortgage loans and rent from real property. On a quarterly basis, seventy five percent of more of a REIT’s asset must be real estate assets such as mortgage loans secured by property as well as the ownership of real property. In addition, 95% of gross income must be from real estate sources but can include some forms of passive income such as interest and dividends from non-real estate sources like interest on a bank deposit. A REIT can also own as much as 100% of the stock of a taxable REIT subsidiary.
There are also distribution rules. To qualify as a REIT, the entity must distribute a minimum of ninety percent of taxable in the form of dividends to its shareholders. The REIT must pay income tax on any income that is not distributed. Shareholders will need to pay taxes on the dividends and any capital gain distributions they receive from the REIT each year.
The company must also make an REIT election by filing Form 1120-REIT with their corporate income tax return. The REIT must also mail letters to all shareholders on an annual basis requesting the details of any beneficial ownership of shares.
Forming a REIT does require organizational, operational and distribution compliance. Adhering to all of the compliance rules takes a great deal of expertise. However, the tax benefits for a Real Estate Investment trust are significant and provide the entity with the means to use most of its capital to invest in real estate properties or loan out on mortgage backed securities and other real estate loans.