A real estate investment trust (REIT) and a limited partnership can own the same apartment building, yet their investors file very different tax returns. The REIT keeps its losses and pays dividends. The partnership passes its losses to its investors, who often can't use them.
Few investors can buy an office tower, but a REIT lets them own a slice of many buildings. The REIT structure is a company that owns or finances real estate. Directors or trustees run it, and transferable shares show who owns it. Compared with owning property directly, a REIT offers diversification, professional management and small minimums. The investor gives up control and can't deduct the properties' losses.
An ordinary corporation pays income tax, and its shareholders pay tax again on its dividends. A REIT avoids corporate tax on the income it distributes, because it may deduct the dividends it pays. It earns that deduction only by qualifying under Internal Revenue Code (IRC) Section 856 each year. The tests keep it focused on real estate and on paying its income out:
Common mistakes
- Quoting the old 20% cap on taxable REIT subsidiaries. For taxable years beginning after December 31, 2025, the cap is 25% of total assets.
- Taxing REIT ordinary dividends at the 15% qualified rate. They are taxed at the marginal rate minus the permanent 20% Section 199A deduction, so 32% becomes 25.6%.
- Calling equity REITs rate-proof. Mortgage REITs are the most rate-sensitive, but rising rates push equity REIT prices down too.
Bottom line
- A REIT avoids corporate tax by meeting the 75% asset test, the 75% and 95% income tests, a 90% payout test and the 100-owner test; taxable REIT subsidiaries are capped at 25% of assets.
- Listed REITs trade at premiums or discounts to NAV; non-traded REITs are illiquid and carry only an estimated value.
- Equity REITs earn rent and follow property values; mortgage REITs earn interest and are the most rate-sensitive; hybrid REITs do both.
- REIT dividends are mostly ordinary income with a permanent 20% Section 199A deduction; capital gain dividends are long-term; return of capital reduces basis; REIT losses never pass through.
Exam shortcut
First decide whether the question is about a REIT or a partnership. A REIT runs on corporate rules, so expect ordinary dividends with the 20% deduction and no losses passed through. A partnership runs through the K-1 and the three loss limits. On any loss question, apply basis, then at risk, then passive. Whatever survives the last limit is this year's deduction.
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Learning objectives
- C17
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