Real Estate Investment Trusts (REITs) Basics: What Paralegals Should Know

What Is a REIT?

A real estate investment trust, or REIT, is a company that owns, operates, or finances income-producing real estate. Congress created the REIT structure in 1960 to give ordinary investors a way to invest in large-scale commercial property, much as mutual funds give access to stocks. A REIT is not necessarily a trust in the traditional sense; it may be organized as a corporation, trust, or association, as long as it meets the tax requirements of the Internal Revenue Code.

REITs are an important subject for paralegals who work in real estate, corporate, securities, or tax law. Even if the paralegal exam does not test them in depth, you may see questions on entity types, pass-through taxation, and real estate holdings. Use the ParalegalPrep flashcards to master related definitions.

How a REIT Works

A REIT pools capital from many investors and uses it to buy or finance properties such as apartment complexes, shopping centers, office buildings, hospitals, hotels, warehouses, data centers, and cell towers. The REIT earns income from rents or interest and distributes most of it to shareholders as dividends. In exchange for distributing most taxable income, the REIT generally avoids corporate-level income tax on the distributed portion. This gives rise to a single level of taxation, at the shareholder level, which resembles pass-through treatment.

Qualification Requirements

To qualify as a REIT, an entity must satisfy a number of tests each year. The most commonly cited requirements include:

• Organization. It must be taxable as a domestic corporation, managed by directors or trustees, and have transferable shares.
• Ownership. It must have at least 100 shareholders, and no more than 50 percent of the value of its shares may be held by five or fewer individuals during the last half of the taxable year (the "5/50 rule").
• Asset test. At least 75 percent of total assets must consist of real estate assets, cash, and government securities.
• Income tests. At least 75 percent of gross income must come from real estate sources such as rents and mortgage interest, and at least 95 percent from those sources plus other passive income such as dividends and interest.
• Distribution requirement. It must distribute at least 90 percent of its taxable income to shareholders annually.

Failure to meet the tests can cause loss of REIT status and the associated tax advantages, so compliance monitoring is a continuing task.

Types of REITs

Equity REITs

Equity REITs own and operate properties and earn income from rent. They are the most common type and include retail, residential, industrial, healthcare, and office REITs.

Mortgage REITs

Mortgage REITs, sometimes called mREITs, provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities. They earn income from interest and are sensitive to interest rate changes.

Hybrid REITs

Hybrid REITs combine both strategies.

Public, Non-Traded, and Private REITs

• Publicly traded REITs are registered with the Securities and Exchange Commission and listed on a national exchange. They provide liquidity and transparency.
• Public non-traded REITs are registered with the SEC but do not trade on an exchange, which makes shares less liquid and often subject to redemption limits.
• Private REITs are not registered, are offered under exemptions such as Regulation D, and typically sell to accredited investors.

Legal Documents in REIT Work

A REIT transaction involves a wide range of documents:

• Articles of incorporation or declaration of trust, including ownership limitation provisions that protect REIT status.
• Bylaws and board resolutions.
• Registration statements, prospectuses, and periodic reports filed with the SEC.
• Purchase and sale agreements for property acquisitions and dispositions.
• Loan agreements, mortgages, deeds of trust, and guaranties.
• Operating partnership agreements, since many REITs use an UPREIT structure.
• Leases with tenants and property management agreements.

The UPREIT Structure

In an umbrella partnership REIT, or UPREIT, the REIT holds its properties through an operating partnership. A property owner can contribute real estate to the operating partnership in exchange for partnership units, deferring recognition of gain for tax purposes. The units can later be converted into REIT shares. This structure is popular because it helps sellers defer capital gains taxes while allowing the REIT to acquire properties.

Advantages and Risks

Advantages

• Access to diversified real estate for small investors.
• Regular dividend income.
• Professional management.
• Liquidity for listed REITs compared with direct ownership.

Risks

• Sensitivity to interest rates and real estate cycles.
• Illiquidity of non-traded REITs.
• Fees and conflicts of interest with external advisors.
• Dividends generally taxed as ordinary income, subject to deductions available under current law.

Paralegal Tasks in REIT Practice

Paralegals support REIT work by preparing closing checklists, conducting entity and good standing searches, ordering title and surveys, compiling due diligence materials, drafting resolutions, tracking filing deadlines such as Forms 10-K, 10-Q, and 8-K, assembling closing binders, and maintaining minute books. In a large acquisition, a paralegal may manage hundreds of leases and estoppel certificates. Strong organizational skills, attention to detail, and familiarity with real estate terminology are essential.

Frequently Asked Questions

Is a REIT a corporation or a trust?

It can be either, or even an association. The label matters less than meeting the tax qualification tests.

Why must a REIT distribute 90 percent of income?

The distribution requirement is the price of avoiding corporate-level tax. It ensures income flows through to investors.

Can a REIT own anything other than real property?

Yes, within the asset tests. It may hold cash, government securities, mortgages, and some securities of taxable REIT subsidiaries, but at least 75 percent of assets must be qualifying real estate assets.

What is a taxable REIT subsidiary?

A corporation owned by a REIT that can engage in activities that would otherwise jeopardize REIT status, such as providing certain services to tenants. It pays ordinary corporate tax.

Keep Building Your Knowledge

Understanding REITs strengthens your grasp of real estate finance, entity law, and securities regulation. Sign up for ParalegalPrep, practice with the real estate flashcards, and check the options on our pricing page to get started.