Section 3Function 3: Investment Products, Recommendations & Records
Real estate investment trusts (REITs)
36 min read
· Lesson 11 of 19
About This Lesson
You arrive here straight from the DPP chapter, and that is deliberate: REITs define themselves against DPPs, and the exam writes questions that live exactly on that line. The good news is that this is one of the lighter lifts in the products module. A handful of structural facts, one tax rule that does most of the work, and a short list of traps that repeat on every administration. If you can answer three questions about any REIT, what it holds, how its dividend is taxed, and what happens to its losses, you can handle nearly everything the Series 7 throws at you here.
What you'll cover
what a REIT is, why investors use one, and the three types (equity, mortgage, and hybrid) with the customers each suits
what a REIT is not: not an investment company under the 1940 Act, and emphatically not a DPP
the IRS qualification tests, the 90% distribution requirement, and how REIT dividends land on your customer's tax return
This is the eleventh chapter of the products module.
A REIT is a company that owns, operates, or finances income-producing real estate. Buy a share and you hold a slice of an apartment portfolio, a stack of office towers, or a book of mortgages, with no tenants to manage, no roof to replace, and no mortgage of your own to service. That is the pitch: real estate income with stock-market liquidity. Publicly traded REIT shares change hands on exchanges all day like any other equity, and because the market sets the price, they routinely trade at a premium or discount to the value of the real estate underneath.
The structure only works because of its tax treatment, and the tax treatment has to be earned. A REIT that passes the IRS qualification tests pays no corporate tax on the income it distributes, and keeping that status means paying out at least 90% of taxable income to shareholders as dividends every year. Section 3 walks through the full battery of tests; the 90% requirement is the one the exam asks about most, so let it start sinking in now.
REIT Types: Equity, Mortgage, and Hybrid
Equity REIT
Owns and operates income-producing real property directly — apartments, office buildings, shopping centers, warehouses. Income comes from rents. Most common type.
Capital appreciation potential
Mortgage REIT
Lends money to real estate owners and operators, or invests in existing mortgages and MBS. Income comes from interest. Highly sensitive to interest rate changes.
High interest rate sensitivity
Hybrid REIT
Combination of equity and mortgage REIT characteristics. Owns properties and also invests in mortgages. Less common.
Both income streams
The Three Types, and Why the Differences Matter
The cards above give you the identities. What the exam actually tests is the economics underneath: a REIT is classified by what its portfolio holds, and that one fact drives where the income comes from, what the risks are, and which customer the REIT suits.
Type
What It Holds
Primary Income Source
Equity REIT
Direct ownership of income-producing real estate (apartments, offices, retail, industrial)
Rental income from property tenants. Most common REIT type. Sensitive to occupancy rates and property values.
Mortgage REIT
Mortgage loans and mortgage-backed securities, not physical property
Interest income from the mortgage portfolio. Highly sensitive to interest rate changes; often uses leverage to amplify spread.
Hybrid REIT
A mix of property ownership and mortgage holdings
Combination of rental income and mortgage interest income. Diversification across both sub-strategies.
Here's the intuition to carry into the questions. An equity REIT lives on occupancy and property values; a recession hurts it twice, shrinking the rent roll and marking down the buildings. A mortgage REIT holds interest-bearing paper, usually on leverage, so rising rates squeeze it from both sides. When a question asks which REIT type is most sensitive to interest rates, the mortgage REIT is the answer. A hybrid REIT simply runs both books at once.
One vocabulary trap: the exam sometimes writes "real estate investment equity trust" instead of "equity REIT," the same property-owning structure under a clunkier name. Mortgage REITs get the same treatment as "real estate investment mortgage trusts." Don't let the word order throw you.
Concept Check
Which of the following is a primary advantage of investing in a REIT compared to direct real estate ownership?
The primary advantage of REITs versus direct real estate is liquidity. Publicly traded REITs can be bought and sold on stock exchanges throughout the day, unlike physical real estate which can take months to sell. REITs also provide professional management and diversification across many properties. Investors do not manage the properties and cannot deduct depreciation on their own returns. Minimum investments are much lower than direct property ownership.
Concept Check
A retail customer purchases shares of a publicly traded REIT focused on commercial office properties. The customer’s ownership represents
REIT shareholders hold an undivided interest in the entire pool of real estate investments owned by the REIT. No individual building, lease, or property is allocated to any specific shareholder. Everyone in the share class participates pro rata in all income and capital appreciation across the full portfolio. Direct title to specific properties characterizes direct ownership of real estate, not REIT investing. Partnership interests describe DPPs, a different structure entirely. Creditor claims would describe bondholders or mortgage REIT lenders rather than equity REIT shareholders.
Concept Check
A registered representative is explaining REITs to a customer unfamiliar with the structure. Which of the following statements about REITs would be INCORRECT?
REITs are NOT investment companies and are NOT regulated under the Investment Company Act of 1940. They are a separate statutory entity type with their own tax-qualification rules under the Internal Revenue Code. Mutual funds, closed-end funds, and unit investment trusts fall under the 1940 Act; REITs do not. The other statements are accurate: publicly traded REITs trade on exchanges and OTC markets providing liquidity, the 90% income distribution test is required for tax pass-through, and the equity/mortgage/hybrid classification correctly captures the three REIT portfolio types tested on the exam.
Concept Check
Which of the following REIT types carries the most interest rate sensitivity?
Mortgage REITs (mREITs) generate income from the spread between the interest earned on mortgage loans/MBS and their borrowing costs. When interest rates rise, this spread can compress significantly — both because the value of their fixed-rate mortgage assets falls AND because their cost of short-term borrowing increases. mREITs typically use leverage (borrowing short, lending long), amplifying their rate sensitivity. Equity REITs own physical properties whose rental income is less directly tied to short-term rate moves.
Concept Check
A customer concerned about a potential rising-rate environment asks about REIT options. Which REIT type would typically be MOST sensitive to a sustained rise in interest rates?
Mortgage REITs are typically most sensitive to interest rate changes because their entire portfolio consists of interest-bearing mortgage paper. Many mortgage REITs use leverage to amplify the spread between short-term funding costs and longer-term mortgage yields, which magnifies rate sensitivity further. When short-term rates rise, funding costs increase and the spread compresses, often forcing dividend reductions. Equity REITs are less directly rate-exposed; their main income source is rental cash flow tied to occupancy and property values, not interest rate spreads. Hybrid REITs sit between the two with partial rate exposure.
Section 2 of 3~8 min · 4 concept checks
REIT Character: Distinctions from DPPs
What a REIT Is Not
REITs sit in a category of their own, and the Series 7 leans on that fact hard. They are not ordinary corporations, not investment companies under the 1940 Act, and, most tested of all, not DPPs. Five characteristics define the structure, and nearly every REIT question is really probing one of them:
Undivided Interest
REIT shareholders hold an undivided interest in a pool of real estate investments. No individual property is allocated to any one shareholder; everyone shares pro rata in the entire pool.
Liquid
Publicly traded REITs trade on exchanges and OTC markets. Shares can be bought and sold continuously like any equity security — a sharp contrast to direct real estate ownership.
NOT Investment Co.
REITs are not investment companies. They are not regulated under the Investment Company Act of 1940 and are not mutual funds or unit investment trusts despite some structural similarities.
NOT a DPP
REITs are not direct participation programs. The two are frequently contrasted on the exam: DPPs flow through both income AND losses; REITs flow through only income, not losses.
Pay Dividends
REITs distribute most of their taxable income as dividends. The dividend payment is a tax-driven design feature, not just a return-of-cash policy.
The default assumption: nontraded REITs exist and have grown in recent years, but unless a question says "nontraded," picture a publicly traded, liquid REIT. Liquidity is part of the standard REIT identity the exam works from.
Concept Check
How does a REIT differ from a DPP in terms of how losses are treated at the investor level?
This distinction is one of the most tested on the Series 7. REITs are corporations (or trusts treated as corporations) — they cannot pass losses through to shareholders. Losses are retained at the REIT level. Investors receive dividends but cannot deduct REIT operating losses on their own returns. DPPs (limited partnerships) are pass-through entities that allocate income, gains, losses, and deductions directly to partners, subject to at-risk and passive activity rules.
Concept Check
Programs that allow direct pass-through of both income AND losses to investors include all of the following EXCEPT
REITs flow income through to shareholders as dividends but do NOT flow operating losses through. Losses remain at the REIT level and cannot be used by shareholders to offset other income. This is the critical distinction from direct participation programs (real estate limited partnerships, oil and gas DPPs) and S corporations, all of which flow both income and losses through to their owners. The pass-through-of-losses question is one of the most commonly tested differentiators between REITs and DPPs on the Series 7. Candidates who recognize REITs as pass-through investments often miss that the pass-through is income-only.
Concept Check
When discussing tax-sheltered investments, the term "direct participation program" (DPP) applies to all of the following EXCEPT
Real estate investment trusts are not direct participation programs. DPPs are organized as limited partnerships and flow both income and losses through to limited partners. REITs are organized as trusts or corporations, flow only income through (as dividends), and shield shareholders from loss pass-through. Oil and gas limited partnerships, real estate limited partnerships, and equipment-leasing limited partnerships are all classic DPPs. The DPP-versus-REIT distinction is structural and tax-mechanical, not just a difference in underlying asset class. The exam consistently tests whether candidates can classify these vehicles correctly.
Concept Check
Depreciation expense generates a tax deduction that flows through to investors in all of the following EXCEPT
REITs do not pass depreciation through to their shareholders. Depreciation deductions reduce REIT taxable income at the entity level, but the benefit stays with the REIT rather than flowing through to individual investors. This is one of several differences between the REIT structure and direct participation programs. Real estate limited partnerships, equipment-leasing limited partnerships, and movie production limited partnerships all flow depreciation through to limited partners along with other income and loss items. For tax-motivated investors specifically seeking depreciation deductions, DPPs offer that benefit while REITs do not.
Section 3 of 3~12 min · 4 concept checks
Taxation: 90% Rule & Dividends
REIT Qualification Requirements and Tax Treatment
Pass-through treatment is not granted; it is earned, every year, against a battery of IRS tests. You do not need to administer these tests, only to recognize them, because the exam pulls its REIT questions straight from this list.
The Qualification Tests
75% asset test: at least 75% of total assets in real estate, mortgages, cash, or government securities.
75% income test: at least 75% of gross income from real estate sources: rents, mortgage interest, and gains on property sales.
95% income test: at least 95% of gross income from those real estate sources plus dividends, interest, and gains from securities sales.
Ownership spread: at least 100 shareholders, and no 5 or fewer people owning more than 50% of the shares (the "5/50 test"). A REIT cannot be a family office in disguise.
The 90% distribution requirement: at least 90% of taxable income paid out to shareholders annually, or the REIT owes corporate income tax. In practice most REITs distribute 95–100%.
What That Means on Your Customer's Tax Return
REIT dividends are ordinary income. Most stock dividends are qualified and get the preferential 15% rate; REIT distributions generally are not, and do not. They land at your customer's full marginal rate. If you remember one REIT tax fact, make it this one; the exam reaches for it more than anything else on the tax side of the chapter.
Losses do not pass through. A DPP hands its losses to the partners; a REIT keeps them. If the REIT runs a net operating loss, your customer gets no deduction, and nothing shows up on the personal return. REITs deliver income, not tax shelter.
Return of capital reduces basis. Any distribution beyond the REIT's earnings and profits is treated as return of capital: it is not taxed now, it simply lowers the investor's cost basis, deferring the tax until the shares are sold.
Capital gains distributions keep their character. When a REIT sells a property it held for more than one year and passes the gain along, the investor reports long-term capital gain, one of the few REIT distributions that is not ordinary income.
REIT vs. DPP, the distinction that keeps showing up: both invest in real estate, but they are built for different jobs. A DPP passes through losses and the deductions that come with depreciation and interest; that is its appeal. A REIT passes through none of that, but in exchange it trades on an exchange like a stock, pays dividends whether or not your customer has passive income to absorb, and never asks for accredited investor status.
The 90% Rule, Up Close
One number does most of the work in REIT taxation. The yields, the dividend policy, the pass-through status: all of it hangs on a single distribution test.
The 90% Income Distribution Requirement
Distribute at least 90% of taxable income to shareholders as dividends and the REIT pays no tax on what it pays out. The income passes straight through, and shareholders report the dividends on their own returns.
Miss the test and the structure collapses: the REIT is taxed as an ordinary corporation, its income taxed once at the entity level and again as a dividend in shareholders' hands. That is the double-taxation outcome every REIT organizes its life to avoid.
Income Flows Through; Losses Do NOT
You met this distinction in Section 2. Here it is again as tax mechanics, because this is where the exam tests it hardest:
REIT Flow-Through
Income flows through to shareholders as ordinary dividends. Losses do NOT flow through — they remain at the REIT level. Shareholders cannot use REIT operating losses to offset other income.
DPP Flow-Through
Both income AND losses flow through to limited partners. Losses can offset other passive income on partner tax returns — one of the major historical attractions of DPP investing.
Exam pattern: when a question asks which structures offer "direct pass-through of losses," the REIT is sitting in the answer choices waiting to be picked by mistake. Income passes through; losses never do. Hold that line and the question answers itself.
Three REIT Facts That Show Up on Every Administration
1. REIT dividends are ordinary income, not qualified. Most stock dividends qualify for the 15% preferential rate. REIT dividends generally do not (with limited exceptions); they are taxed at your customer's full marginal rate. On the exam, "15% rate" and "REIT dividend" should never appear together unless the question is fishing for a wrong answer.
2. REITs do not pass through losses. This is the defining difference from DPPs. A DPP investor with a net operating loss gets a deduction (subject to at-risk and PAL rules); a REIT investor gets nothing, because the losses stay inside the REIT. The moment a question says the customer "needs tax shelter benefits," you are being pointed at a DPP, not a REIT.
3. The 90% distribution requirement avoids double taxation. Distribute at least 90% of taxable income and the REIT pays no corporate income tax on the distributed portion. That is why REIT yields typically beat regular stock dividends: nearly all the income is being passed through rather than retained.
Concept Check
To maintain its REIT status and pass-through tax treatment, a REIT must distribute at least what percentage of its taxable income to shareholders each year?
A REIT must distribute at least 90% of its taxable income to shareholders annually to maintain its tax status as a REIT. By distributing this high percentage, the REIT avoids corporate-level taxation on the distributed income — it is taxed at the shareholder level instead. The retained 10% may be used for reinvestment. This 90% distribution requirement is the most frequently tested REIT rule.
Concept Check
For a REIT to qualify for favorable tax treatment that avoids corporate-level taxation, the REIT must distribute at least what percentage of its taxable income to shareholders as dividends?
A REIT must distribute at least 90% of its taxable income to shareholders to qualify for tax pass-through treatment. Failure to meet the 90% threshold causes the REIT to lose its qualifying status, after which it is taxed as a regular corporation — effectively producing double taxation since shareholder dividends would still be taxed at the personal level. The 50% and 75% thresholds do not correspond to any REIT qualification rule. The 100% figure overstates the requirement; REITs may retain up to 10% of taxable income for reinvestment without losing qualifying status.
Concept Check
A REIT fails to distribute 90% of its taxable income to shareholders in a given year. What is the consequence?
The 90% distribution requirement is a qualification requirement for REIT tax status. If a REIT fails to distribute at least 90% of its taxable income, it loses its REIT classification for that year and becomes subject to full corporate income tax on all taxable income — not just the retained amount. This double taxation (corporate tax at the entity level, then income tax when dividends are paid) is the primary reason REITs are structured to distribute the maximum amount possible.
Concept Check
An investor in an equity REIT receives a $1,200 annual dividend. For federal income tax purposes, this dividend is most likely treated as:
REIT dividends are generally classified as non-qualified ordinary income and taxed at the investor's marginal rate — not at the lower qualified dividend rate. This is because REITs pass through rental income and other business income rather than corporate earnings that have been subjected to entity-level tax. The Tax Cuts and Jobs Act (2017) provides a 20% deduction on qualified REIT income for pass-through purposes, but the dividends are still ordinary income on the Form 1040.
SummaryExam Essentials — high-yield review
Chapter Summary
Ch 18 Exam Essentials — Real Estate Investment Trusts
REIT qualification tests: 75% of assets in real estate/cash/Treasuries; 75% of income from real estate; must distribute at least 90% of taxable income; at least 100 shareholders; no 5 individuals own more than 50% (5-50 test).
90% distribution requirement: Non-negotiable for REIT tax status. Failing to distribute 90% = loss of REIT status = full corporate income tax on all taxable income for that year.
REIT dividends: Generally non-qualified ordinary income (not the lower qualified dividend rate). Taxed at the investor's marginal rate. The 2017 Tax Cuts and Jobs Act provides a 20% deduction on qualified REIT income (Section 199A).
REITs do NOT pass losses through: Unlike DPPs, losses stay at the REIT entity level. Investors receive dividends but cannot deduct the REIT's depreciation or operating losses on their own returns.
Equity vs. mortgage REITs: Equity REITs own physical properties; income from rents. Mortgage REITs (mREITs) hold mortgages and MBS; income from interest. mREITs are more sensitive to interest rate changes due to leverage and rate spread compression.
REIT Exam Traps — Consolidated
Twelve ways the exam tries to trip you on REITs. Scan this list the night before; every one of these has appeared as the hinge of a real question:
1. REIT shareholders hold an undivided interest in a pool of real
estate. No individual property is assigned; everyone shares pro
rata in the entire portfolio.
2. REITs are NOT investment companies. Not regulated under
the 1940 Act. Not mutual funds. Not unit investment trusts.
3. REITs are NOT DPPs. The two structures are explicitly
distinguished. DPPs use limited partnerships; REITs do not.
4. REIT income flows through; REIT losses do NOT flow through.
Shareholders receive dividends from REIT income but cannot deduct REIT
operating losses against other income.
5. REITs are liquid. Publicly traded REITs trade on
exchanges and OTC markets. The standard exam REIT is publicly traded
unless stated otherwise.
6. 90% income distribution test for tax qualification.
Failure to distribute 90% loses pass-through status and triggers
corporate-level taxation.
7. Three REIT types: Equity, Mortgage, Hybrid. Equity
holds property and earns rent. Mortgage holds mortgage paper and earns
interest. Hybrid mixes both.
8. Mortgage REITs are highly rate-sensitive. Their entire
portfolio is interest-bearing paper. Rising rates compress spreads and can
dramatically affect dividend coverage.
9. Equity REITs are sensitive to occupancy and property
values. Recessions affect both rental income and the underlying
real estate values they own.
10. REIT dividends are typically taxed as ordinary income.
Most REIT dividends do NOT qualify for the lower qualified dividend rate
because they come from non-taxed REIT income.
11. Depreciation expense does not pass through to REIT
shareholders. Unlike a real estate DPP where depreciation reduces
investor taxable income, REIT depreciation stays at the REIT level.
12. Nontraded REITs exist but are the exam exception.
Default to publicly traded REITs unless the question explicitly says
"nontraded." Nontraded versions sacrifice liquidity for higher reported
yields.