Understanding REITs: A Complete Guide for Real Estate Investors

Investing in real estate can be complicated, costly and time consuming. However, Real Estate Investment Trusts (REITs) offer a more accessible way to gain exposure to the real estate market. Modern REITs offer investors liquidity, diversification, transparency‑driven security and competitive long‑term performance, with a significant portion of returns delivered through reliable dividend income.

In this guide, we offer the basics of REITs, from types of REITs and organizational requirements, to asset and income tests, to additional perspectives investors should consider.

What is a REIT Investment?

Simply put, a REIT is a company that owns, operates or invests in income-producing real estate. Modeled after mutual funds, REITs allow everyday investors to earn a share of the income produced through commercial real estate ownership, without actually having to go out and buy or manage a building themselves. Then the REIT distributes most of its income as dividends to investors.

The REIT model: Investors → REIT → Properties → Rental income → Dividends back to investors

REIT Basics: Understanding Structure and Types

Understanding the different types of REITs available is critical for investors to select investments aligned with their risk tolerance and goals. Below is a breakdown of each REIT type.

Equity REITs

• Own and operate income-producing real estate
• Generate revenue mainly from rental income
• Manage property operations, leasing and maintenance
• Ideal for investors seeking dividend income and long-term growth

The majority of REITs are equity REITs, so it’s important to understand the various property types, or sectors, they focus on and their unique investment characteristics. Below is a list of the property sectors to consider when considering investing in an equity REIT:

• Office REITs: Own commercial office buildings leased to businesses
• Retail REITs: Own shopping centers, malls and retail complexes
• Industrial REITs: Own warehouses and distribution centers
• Self-Storage REITs: Own, acquire, develop and manage self-storage facilities
• Residential REITs: Own apartment complexes and multifamily housing
• Data Center REITs: Own and operate highly specialized facilities that house servers and network infrastructure
• Hotel/Lodging REITs: Own properties with hotels and resorts
• Gaming REITs: Own properties with casinos and entertainment properties
• Healthcare REITs: Own, acquire, and develop healthcare facilities
• Triple-net REIT: Own single tenant properties under long term leases where tenants pay operating costs, resulting in highly predictable, stable cash flows with modest rent growth
• Timberland REITs: Own land used for timber production

Selecting a sector should align with market trends and your appetite for risk as an investor.

Mortgage REITs (mREITs)

• Invest in real estate debt, lending money to property owners or buying mortgage-backed securities
• Earn revenue primarily from interest on loans
• Are sensitive to interest rate changes, offering higher risk and potentially higher yield

Hybrid REITs

• Combine equity and mortgage strategies
• Provide diversified income streams from both rental properties and mortgage interest

Any of the types of REITs discussed above can be public or private, each with their own set of advantages and disadvantages.

Public vs. Private REITs

It’s important for investors to understand the difference between public and private REITs because each has very different liquidity, risk and valuation characteristics. In general:

• Publicly listed REITs trade on stock exchanges and are highly liquid.
• Public, non-listed REITs are registered with the SEC but do not trade publicly.
• Private REITs are not SEC-registered and shares are not publicly traded; these REITs are usually for accredited investors and often are highly advantageous for tax-exempt and foreign investors.

Tax‑exempt investors — such as pension funds, endowments, foundations and IRAs — must pay close attention when they are investing in real estate funds structured as partnerships, because the decision can affect tax exposure, reporting complexity and investment flexibility.

For example, tax-exempt investors are highly sensitive to unrelated business taxable income (UBTI) when investing in real estate or operating businesses. This is why structures often include special tax strategies to preserve their tax‑exempt status. Foreign investors, particularly sovereign wealth funds and foreign pensions, require structures that avoid effectively connected income (ECI) and Foreign Investment in Real Property Tax Act (FIRPTA) exposure, and maintain eligibility for exemptions such as Section 892. This often necessitates the use of REITs, C Corporations and careful ownership and exit planning.

These investor‑driven tax sensitivities significantly dictate the type of REIT an investor chooses. As a result, many tax-exempt and foreign investors choose private REITs for their flexibility and ability to help manage tax exposure.

>> Our Take: Publicly listed REITs are generally easier to buy and sell, while private REITs may offer specialized opportunities but higher entry requirements.

What are the Key Tax Considerations of a REIT Investment?

REITs offer tax advantages by providing a single-layer tax structure, avoiding federal corporate income tax, and allowing more income to pass to investors. However, a REIT must follow very strict requirements.

Key Tax Features of REITs

• Corporate structure: REITs are treated as corporations for federal tax purposes.
• Corporate taxation: The cornerstone of understanding REIT tax basics is the dividends paid deduction. Unlike standard C Corporations, a REIT can deduct the dividends it pays to shareholders from its taxable income, effectively eliminating federal corporate level tax.
• Shareholder taxation: Investors pay tax on dividends they receive. Section 199A allows individuals to deduct up to 20% of ordinary REIT dividends, providing a meaningful rate reduction without the wage or asset limitations that apply to operating businesses.

90% Distribution Requirement for REITs — Explained

To maintain REIT status, a REIT must distribute to its shareholders at least 90% of its REIT taxable income each taxable year, excluding net capital gains. If this requirement is met, the REIT is generally allowed a dividends‑paid deduction, eliminating federal corporate level tax on the distributed income.

What Counts as “REIT Taxable Income”?

Understanding what counts as REIT taxable income is important because it determines the amount a REIT must distribute to shareholders each year to maintain its favorable tax status.

• Taxable income is calculated after deductions, including depreciation, but before the dividends‑paid deduction.
• Capital gains are excluded from the 90% calculation and are subject to separate distribution rules.
• Taxable income often differs materially from cash flow due to depreciation and timing differences.

A REIT can satisfy the 90% requirement without distributing cash, using IRS‑permitted mechanisms such as:

• Elective stock dividends (with minimum cash component requirements for listed REITs), and
• Consent dividends, where shareholders agree to include income and increase stock basis.

These distributions are treated as taxable dividends for purposes of the REIT rules.

Relationship to the 4% Excise Tax

The 90% rule is separate from the excise tax distribution thresholds:

• To avoid a 4% excise tax, a REIT must generally distribute:
  • 85% of ordinary income, and
  • 95% of capital gain income, during the calendar year

A REIT may meet the 90% requirement yet still owe excise tax if these higher thresholds are not satisfied. Most REITs distribute 100% of their taxable income, so as to avoid any corporate taxes.

It’s important to note, unlike partnerships or LLCs, REITs are not pass-through entities. Losses and tax credits do not flow through to shareholders.

Additional Tax Considerations for REITs

Below are a few other key tax concerns to consider:

• Prohibited transactions: A REIT is subject to a 100% tax on gains from property sales treated as dealer activity, such as selling assets in the ordinary course of business, e.g., condo flips. While statutory safe harbors and structuring alternatives exist, they require careful upfront planning to avoid punitive taxation.
• Foreclosure property: When a REIT acquires property through a loan or lease default and the income from that property does not qualify under the 75% income test, the REIT may still preserve its status. However, the net income is taxed at the corporate rate rather than passed through tax‑free. This regime is intended as relief and avoids prohibited transaction treatment.
• Insufficient distributions: Although a REIT must distribute at least 90% of taxable income to maintain REIT status, retaining income can still trigger taxes. Retained ordinary income is subject to 21% corporate tax, retained capital gains generate a shareholder‑level tax credit, and failure to distribute 85% of ordinary income and 95% of capital gains results in a 4% excise tax, making precise distribution planning critical.

Tax Differences Between REITs, Partnerships and LLCs

Below is a high level look at how REITs differ from partnerships and LLC structures in terms of taxation:

>> Our Take: Investors seeking stable dividend income may prefer REITs, while partnerships generally suit those looking for tax loss benefits.

REIT Compliance: Organizational and Operational Requirements

To qualify as a REIT under U.S. tax law, companies must meet several requirements:

• Shareholder base: Minimum 100 shareholders for 335 days of the year (or a proportionate period for a short year). This requirement does not apply in the first REIT year.
• Closely held restrictions: No more than 50% owned by five or fewer individuals in the last six months of the tax year.
• Calendar year: Generally required for REIT taxation.
• Corporate structure: Must be a corporation, trust or association with transferable shares.
• Election: File Form 1120-REIT to elect REIT taxation.
• Management: Must be managed by one or more trustees or directors.
• Transferability: Shares must be transferable, subject to customary ownership limitations designed to protect REIT qualification.
• Termination and Revocation: Loss of qualification or voluntary revocation triggers C Corporation taxation and a five-year waiting period before reelection.

Compliance with these requirements is essential to preserve the favorable tax treatment of REITs.

Asset Tests for REIT Qualification

REITs must satisfy quarterly asset tests to ensure the majority of investments are in real estate. This is measured based on gross assets at fair market value.

75% Asset Test

At least 75% of REIT’s total assets must consist of:

• Real estate assets (real property, interests in real property, interests in mortgages on real property and shares of other REITs)
• Cash and cash items (including certain receivables)
• Government securities

25% Taxable REIT Subsidiaries (TRS) Test

REITs must monitor their investments in taxable REIT subsidiaries carefully due to limits within the tax code. No more than 25% of total assets may be invested in one or more TRSs (effective 1/1/2026).

5% and 10% Tests (non-TRS securities)

To maintain REIT qualification, the tax rules also limit a REIT’s exposure to non-TRS securities. A REIT:

• Cannot have more than 5% of assets in securities of a single issuer.
• May not own more than 10% of outstanding securities of a single issuer by vote or value (excluding a TRS).

Asset Test Failure

Asset test failures do not automatically disqualify a REIT, but timely cures, documentation and potential penalty taxes are required to preserve REIT status.

>> Our Take: Investors will want to maintain accurate quarterly asset valuations to avoid inadvertent violations.

Income Tests for REIT Qualification

Income tests ensure most of a REIT’s revenue comes from real estate sources.

• 75% Gross Income Test: At least 75% of a REIT’s gross income each taxable year must come from real‑estate‑related sources, including rents from real property, interest on mortgages secured by real property (and certain mezzanine loans), gains from the sale of real property that is not dealer property, dividends from other REITs and income from foreclosure property.
• 95% Gross Income Test: At least 95% of gross income must come from qualifying passive sources, which include all income qualifying for the 75% test plus interest, dividends and gains from the sale of securities. Nonqualifying “bad income,” such as fees from managing properties the REIT does not own is generally limited to 5% of gross income.
• 1% Impermissible tenant services income (ITSI) test: Impermissible tenant services income arises when a REIT directly provides noncustomary or convenience services to tenants. Exceeding the 1% property‑level threshold can taint all rents from that property for REIT income test purposes.

Failure and Relief Provisions

A REIT that fails either income test does not automatically lose REIT status if the failure is due to reasonable cause and not willful neglect. If due to reasonable cause, the REIT must pay a penalty tax based on the income shortfall, making proactive income classification and monitoring critical.

Bad Income Rules

To maintain REIT qualification, a REIT must carefully monitor its income sources, as the tax rules restrict the amount of non-qualifying, or “bad,” income a REIT can earn to ensure the majority of its revenue is derived from real estate–related activities. That means:

• Up to 5% of gross income may come from nonqualifying sources, such as management fees from non-owned properties.
• Rent based on tenant profits or services exceeding thresholds is nonqualifying.

Practical Tips:

• Management fees for properties the REIT owns are self-charged and generally ignored for the bad income calculation.
• Ensure impermissible tenant services do not exceed de minimis thresholds.

"At-A-Glance" Compliance

REITs Offer Opportunity for Your Portfolio, When Coupled with Discipline

REITs are a powerful tool for investors seeking exposure to real estate without direct property ownership. They offer liquidity, for publicly traded REITs; diversification of your portfolio, offering access to multiple property sectors; and regular income in the form of dividend distributions backed by real estate revenue.

However, REITs come with strict organizational, asset and income test requirements. Understanding these rules is crucial for operators and investors alike to preserve tax advantages and maximize returns. For investors, REITs can be a cornerstone of a balanced portfolio, providing income stability and growth potential, while offering a hands-off approach to real estate investing.

Contact Asha Shettigar, Agata Orzechowska or a member of your service team to discuss this topic further.

In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.