Internal Revenue Code Section 856

Definition

Internal Revenue Code Section 856 outlines the requirements for a Real Estate Investment Trust (REIT) to qualify for special tax considerations. This section lays down the criteria that a REIT must meet, such as asset composition, income distribution, and operational guidelines, which are crucial for taxation purposes and the types of REITs that can be formed.

5 Must Know Facts For Your Next Test

1. To qualify as a REIT under Section 856, at least 75% of a REIT's total assets must consist of real estate assets.
2. A REIT must derive at least 75% of its gross income from real estate-related sources to meet the income tests set by Section 856.
3. Internal Revenue Code Section 856 mandates that a REIT must distribute at least 90% of its taxable income annually to shareholders to maintain its special tax status.
4. REITs can be categorized into equity REITs, which primarily own and operate income-generating real estate, and mortgage REITs, which mainly provide financing for income-producing real estate.
5. Failure to comply with the requirements of Section 856 can result in the loss of a REIT's tax benefits and subject it to corporate taxation.

Review Questions

• What are the key asset and income composition requirements for a REIT under Internal Revenue Code Section 856?
  • Under Internal Revenue Code Section 856, a REIT must ensure that at least 75% of its total assets are composed of real estate assets and at least 75% of its gross income is derived from real estate-related sources. This means that rental income from properties and interest from mortgages play a crucial role in meeting these requirements. By adhering to these guidelines, a REIT can maintain its tax-advantaged status while providing returns to its investors.
• Discuss the significance of the distribution requirement imposed by Internal Revenue Code Section 856 on REIT operations.
  • The distribution requirement outlined in Internal Revenue Code Section 856 mandates that a REIT must distribute at least 90% of its taxable income to shareholders in the form of dividends. This requirement is significant because it ensures that investors receive consistent returns on their investments while also allowing the REIT to avoid corporate-level taxation. By prioritizing these distributions, REITs attract investors looking for steady income streams while maintaining their favorable tax treatment.
• Evaluate how failure to comply with Internal Revenue Code Section 856 affects a REIT's operational strategy and financial performance.
  • If a REIT fails to comply with Internal Revenue Code Section 856, it risks losing its tax-advantaged status, resulting in corporate-level taxation on its earnings. This can significantly impact the REIT's operational strategy as it may have to adjust its asset composition and income generation methods to regain compliance. Moreover, the financial performance of the REIT could decline due to increased tax liabilities and reduced cash flow available for dividends, leading investors to reassess their commitments and possibly resulting in diminished market confidence.

Related terms

REIT: A Real Estate Investment Trust is a company that owns, operates, or finances income-producing real estate, allowing investors to earn a share of the income without having to buy, manage, or finance any properties themselves.

Qualified Income: Qualified income refers to specific types of income that a REIT must generate, such as rental income or interest from mortgages, in order to meet the requirements of Internal Revenue Code Section 856.

Distribution Requirement: The distribution requirement mandates that a REIT must distribute at least 90% of its taxable income to shareholders in the form of dividends to maintain its tax-advantaged status.