Income testing is a vital aspect of compliance for real estate investment trusts (REITs). These income tests are based on the gross income, as computed for tax purposes, from the various properties that a REIT owns, including the REIT’s share of income from underlying partnerships (based on its capital ownership).
By law, these tests must be performed on an annual basis; violation of any compliance rules may result in a severe financial penalty and even revocation of REIT status. It is recommended, however, that the REIT perform income tests on a quarterly basis to identify and resolve any issues in a timely manner that might otherwise compromise the results of the annual income test.
The two income tests
The 75 percent test: Real estate
The 75 percent gross income test is comprised solely of real estate income. At least 75 percent of a REIT’s gross income must be derived from:
- Rents from real property
- Interest on obligations secured by mortgages on real property
- Gain from the sale or other disposition of real property
- Income and gain from foreclosure property and REIT stock
- Abatements and refunds of real estate taxes
- Certain amounts received as consideration for entering into agreements to make loans and/or purchase lease property
- Certain qualified temporary investment income
Rents from real property is defined to include:
- Charges for services customarily furnished in connection with rental of real property
- Rent attributable to personal property, which is leased under, or in connection with a lease of real property
Rent attributable to personal property is only qualifying income if the fair value of personal property is less than 15 percent of the fair value of all real and personal property included in the lease, based on average fair value at the beginning and end of the tax year.
There are certain sources of income that are excluded from rents. Rents that are based on the sharing of net profits are nonqualifying. This can most often be seen in retail properties when a portion of a tenant’s rent is fixed, and the other portion varies based on the net profits of the store that occupies the space. Conversely, the sharing of gross profits between tenants and the REIT is acceptable. Similar rules regarding fixed and variable rate mortgages also apply to interest income for mortgage REITs.
Rents derived from a related party or impermissible tenant services (described below) are also excluded. A tenant is considered a related party if the REIT owns 10 percent or more of the assets or net profits (for non-corporate entities) or 10 percent or more of the voting power or value (for a corporation).
The 95 percent test: Real estate and portfolio
REITs must also comply with the 95 percent gross income test. While this test holds a higher threshold regarding income, it also allows for a greater variety of sources of that income. This test requires that 95 percent of a REIT’s income be comprised of real estate and portfolio income. All of the real estate income from the 75 percent test qualifies for the 95 percent test.
In addition to the sources of qualified income for the 75 percent test, interest income, dividend income, and gain from the sale or disposition of stock and securities are also qualifying sources of income for purposes of the 95 percent test.
It is important to note, however, that certain sources of income are excluded from these tests, including but not limited to:
- Prohibited transaction income
- Cancellation of indebtedness income
- Income from certain types of hedging transactions
Impermissible tenant service income
Impermissible tenant service income (ITSI) is any income received or accrued directly or indirectly by a REIT for generally noncustomary services furnished or rendered by the REIT to tenants of the property. ITSI is not considered qualifying income for either the 75 percent or the 95 percent tests. If ITSI exceeds 1 percent of a property’s gross income, all income attributable to that property is considered tainted and not included as qualified income for the income tests.
Aside from basic asset and property management functions, many REITs use independent contractors or taxable REIT subsidiaries rather than REIT employees to provide services. An independent contractor is any person who does not own, directly or indirectly, more than 35 percent of the shares in the REIT. If the independent contractor is not an individual, the REIT also cannot own directly or indirectly 35 percent or more of the interest in assets or net profits (for noncorporate entities) or 35 percent or more of the voting power or number of shares (for a corporation). The indirect test is assessed by determining if one or more persons owning 35 percent or more of the shares in the trust have ownership in the contractor entity.
In addition, a REIT cannot receive or derive any income from an independent contractor and the independent contractor must be adequately compensated in an arm’s-length manner.
Generally, impermissible services are those that fall outside the scope of typical and customary services provided by an independent contractor. The determination of whether a service is customary is based on the facts and circumstances of each case. It requires extensive knowledge of the market in coordination with an understanding of various relevant IRS private letter rulings. Property managers are typically the best source of market information, as typical and customary services vary not only across regions but across property types.
REITs must always be compliant with the annual 75 and 95 percent gross income tests. Passing these tests must be considered not only when REITs look to acquire new properties, but also during ongoing operations at existing properties. A careful review of all sources of a REIT’s income is essential to maintaining tax-favorable REIT status.