A real estate investment trust pays little or no entity-level income tax, but only if it meets a set of tests in the Internal Revenue Code every year. For the audit, that has two effects. The financial statements carry real estate accounting risks common to any property owner, and the income tax accounting rests on a compliance question that the firm needs to understand even when it is not testing tax returns line by line.
The statutory qualification tests
The tests sit in IRC sections 856 and 857.
- Ownership. Shares must be held by 100 or more persons, for at least 335 days of a 12-month taxable year. The entity must also not be closely held under the rules of section 856(h). Neither ownership test applies in the first taxable year of the REIT election. It must be managed by trustees or directors and have transferable shares.
- Asset test. At the close of each quarter, at least 75 percent of the value of total assets must be real estate assets, cash and cash items, and government securities. Securities outside that group cannot exceed 25 percent of total asset value, and securities of taxable REIT subsidiaries are capped at 25 percent of total assets for taxable years beginning after December 31, 2025 (20 percent for earlier years). Securities of any one issuer cannot exceed 5 percent of total assets, and the trust cannot hold more than 10 percent of the voting power or value of any one issuer.
- 75 percent income test. At least 75 percent of gross income, excluding prohibited transaction income, must come from a narrow set of sources, mainly rents from real property, mortgage interest and gains from sales of real property.
- 95 percent income test. At least 95 percent of gross income must come from those sources plus dividends, interest and gains from stock and securities.
- Distribution. Under section 857(a)(1), the dividends-paid deduction must be at least 90 percent of REIT taxable income, computed without the dividends-paid deduction and excluding net capital gain, subject to adjustments for foreclosure property and excess noncash income.
Qualification is not permanent. It is re-established every taxable year, and a failure can trigger penalty taxes or loss of REIT status, depending on the test and whether a cure provision applies.
Impermissible tenant service income, meaning services beyond what is customary for the property type, can cause rents to fail the income tests. Rents from a property and the related services therefore need to be mapped by income type.
GAAP versus REIT taxable income
REIT taxable income differs from GAAP net income, and depreciation is one source of the difference. That means the distribution requirement is measured on a number that does not appear in the audited statements. The auditor reads the tax provision workpapers, understands the reconciliation and tests the dividends declared and paid. Dividends declared in October, November or December to shareholders of record on a specified date in that month, and actually paid in January, are treated as paid on December 31 of the declaration year under section 857(b)(9), so the timing of declaration is a cutoff item.
GAAP topics for real estate investments
- Acquisitions. Decide whether the purchase is a business combination or an asset acquisition. Allocate cost to land, building, tenant improvements and in-place lease intangibles. See business combination.
- Depreciation. Test useful lives and the allocation between land and depreciable components.
- Lessor income. Operating lease income is straight-line over the lease term when collectibility is probable. See real estate lessor revenue.
- Impairment. Test indicators under ASC 360. See ASC 360 and ASC 350 impairment.
- Fair value. Some REITs use fair value for investments; see fair value measurement.
- Consolidation. Joint ventures and operating partnerships need a variable interest entity analysis.
Risk areas
- Quarter-end asset tests prepared late or not at all
- Income that does not meet the rents from real property definition
- TRS securities near the 25 percent cap after an acquisition
- Distribution shortfalls near the filing date
- Prohibited transaction exposure from frequent property sales
- Related-party management and advisory fees
- Stock ownership concentration in private REITs
Audit procedures
- Obtain management's qualification memo and quarterly asset test calculations.
- Recompute the asset test for each quarter-end from the balance sheet, with fair value support for assets measured differently for tax.
- Map gross income by type and recompute the 75 and 95 percent tests.
- Test shareholder count using the stock transfer agent or the shareholder register.
- Test the distribution by comparing dividends declared and paid to estimated taxable income.
- Vouch acquisitions to closing statements and test the purchase price allocation.
- Test rental revenue against leases and rent rolls, including straight-line rent receivable.
- Evaluate the tax provision for the entity, taxable REIT subsidiary and any state taxes.
- Assess going concern where debt maturities exceed available liquidity.
Worked example
This example is illustrative. At June 30, 2026, a REIT has total assets of $200,000,000, made up of $150,000,000 of real estate assets, $8,000,000 of cash, and $42,000,000 of securities in a taxable REIT subsidiary.
- Real estate plus cash: $158,000,000
- Percent of total assets: 79 percent, which meets the 75 percent test
- TRS securities: $42,000,000, or 21 percent, which is inside the 25 percent cap
The REIT then sells $20,000,000 of real estate and uses the proceeds to buy additional TRS securities. Total assets stay at $200,000,000, but real estate plus cash falls to $138,000,000 (69 percent), and TRS securities rise to $62,000,000 (31 percent). Both tests fail (75 percent minimum and 25 percent maximum). The auditor tests the asset test at every quarter-end after an investment, because a single transaction can fail it and the cure paths are limited and time-bound. The memo documents the cure analysis and the effect on the tax provision.
PBC items
- REIT election, charter and bylaws
- Quarterly asset test and annual income test calculations
- Shareholder register and transfer agent reports
- Taxable income and E&P estimates and dividend declarations
- Acquisition files, purchase price allocation and valuation reports
- Rent rolls, lease abstracts and straight-line schedules
- Debt agreements and covenant calculations
- Operating partnership and joint venture agreements
- Tax provision workpapers, including TRS
Red flags
- Management cannot produce quarterly asset test workpapers
- Rental income including fees for non-customary services
- A sudden increase in TRS investments
- Dividends declared at year end without cash to pay them
- Frequent sales of properties held for a short time
- Tenant concentration, with rent deferrals
Sources
- 26 U.S.C. 856, Definition of real estate investment trust (law.cornell.edu/uscode/text/26/856)
- 26 U.S.C. 857, Taxation of real estate investment trusts and their beneficiaries (law.cornell.edu/uscode/text/26/857)
- Wiss, "REIT Compliance Checklist" (wiss.com/reit-compliance-checklist)
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