Private lending fund managers face a critical decision in 2025: whether to incorporate a Real Estate Investment Trust (REIT) structure into their operations. With legislative developments solidifying the future of key tax provisions, understanding how mortgage REITs function within the private lending ecosystem has never been more important.
This guide examines the strategic value of mortgage REITs, the compliance requirements fund sponsors must satisfy, and practical considerations for implementation.
Why Mortgage REITs Matter for Private Lenders
The relationship between mortgage REITs and private lending gained significant momentum following the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017. That legislation introduced Section 199A, which established a 20% qualified business income deduction for pass-through entities. While the deduction for ordinary pass-through businesses is subject to income thresholds, Section 199A extends the same deduction to REIT dividends without those limitations.
This distinction made REITs an attractive structural component for private lending funds. For taxable investors in a debt fund, the 20% deduction on REIT dividends meaningfully reduces the tax burden on what would otherwise be ordinary income, the least favorable category from a tax perspective.
The Legislative Outlook
The extension or permanence of Section 199A has been a central concern for fund managers since the provision was originally set to sunset at the end of 2025. Following the 2024 election results, the consensus among industry professionals is that an extension is virtually certain, likely through budget reconciliation. Whether the extension spans five years, seven years, or becomes permanent remains to be seen, but the directional trajectory favors continuation.
For fund sponsors who deferred the REIT decision while awaiting political clarity, the current environment strongly supports moving forward with implementation.
Key Benefits Beyond the Tax Deduction
While the Section 199A deduction is the headline benefit, mortgage REITs offer three additional advantages that are particularly valuable for larger funds.
Blocking Unrelated Business Taxable Income (UBTI)
Debt funds that utilize leverage and accept capital from tax-exempt investors face UBTI exposure. For non-taxable organizations such as endowments, charitable foundations, and certain insurance companies, UBTI is a disqualifying factor. These institutional investors literally cannot participate in investments that generate UBTI without jeopardizing their tax-exempt status.
A REIT structure blocks UBTI entirely, opening the door to a significant pool of institutional capital that would otherwise be inaccessible.
Eliminating State Withholding and Reporting Obligations
Funds that originate loans across multiple states face substantial administrative costs related to state-level tax withholding and reporting for each investor. The REIT structure eliminates these obligations, which can represent meaningful savings for multistate lending operations.
Passive Business Treatment for Foreign Investors
Private lending funds are typically classified as active trader businesses due to the nature of the lending operations. This classification creates effectively connected income (ECI), which prevents many foreign investors from participating. A REIT blocks the active trader business designation, enabling the fund to attract overseas capital without ECI concerns.
REIT Compliance: The Four Essential Tests
Operating a REIT requires ongoing compliance with specific testing requirements. Understanding these obligations before implementation is critical.
The 100 Investor Test
A REIT must maintain at least 100 investors by January 30th of the calendar year following its REIT election. While this may initially appear burdensome, a well-established industry of shareholder accommodator services exists specifically to help funds satisfy this requirement. These vendors provide preferred equity investors, which the IRS has confirmed count toward the 100 investor threshold.
For funds above $30 to $50 million, onboarding with a shareholder accommodator is generally straightforward. Smaller funds may encounter additional requirements from accommodator firms, such as escrow arrangements or enhanced documentation, but options remain available.
The 75% Asset Test
At least 75% of a REIT’s assets must be held in real estate-related assets. For mortgage REITs in the private lending space, this test is rarely problematic. Loan portfolios secured by real property, REO assets, cash holdings, and Treasury securities all qualify. Most private lending funds naturally satisfy this requirement through their core business operations.
The 90% Distribution Test
A REIT must distribute at least 90% of its taxable income annually. However, best practice dictates distributing 100% because REITs are taxed as C corporations. Any retained income faces taxation at the corporate rate, making full distribution the optimal approach.
This distribution requirement is one of the primary reasons the subsidiary REIT strategy (discussed below) is preferred over direct conversion.
The Closely Held Test (Five-and-Fifty)
This is the most consequential test and the one without a simple workaround. The closely held test prohibits five or fewer individuals from owning 50% or more of the REIT on a fully diluted basis.
The IRS applies a broad definition of “individual” in this context, requiring attribution up and down the family tree: parents, grandparents, children, grandchildren, and notably, siblings. Fund managers must look through all entity layers and trusts to identify the underlying natural persons, then aggregate family accounts.
The closely held test does not apply immediately upon REIT election. Instead, compliance is required during the second half of each tax year following election. This buffer period gives sponsors time to diversify their investor base.
The Subsidiary REIT Strategy: The Preferred Approach
Rather than converting an entire fund to REIT status, the legal and industry consensus strongly favors the subsidiary REIT (sub-REIT) approach. This structure places a REIT subsidiary beneath the parent fund, with the sub-REIT holding the qualifying loan assets.
Why the Sub-REIT Strategy Works
Preserving Fund Flexibility. Converting an existing fund to REIT status requires material amendments, investor votes, and restructuring of waterfall and fee arrangements. A subsidiary REIT avoids all of this disruption because the parent fund’s terms remain unchanged.
Meeting Distribution Requirements. The sub-REIT dividends all income up to the parent fund, satisfying the 90% (or 100%) distribution test. The parent fund then distributes capital according to its existing waterfall, maintaining the established investor experience.
Disposability. If a REIT violates compliance requirements or the sponsor decides the structure no longer serves its purpose, unwinding a subsidiary REIT is far simpler than unwinding the entire fund. The parent fund continues operating without interruption.
Isolating Non-Qualifying Assets. Certain loan types, including shared appreciation mortgages and loans with profit participation components, do not qualify for REIT treatment. The sub-REIT structure allows the parent fund to hold these non-qualifying assets while the subsidiary holds only eligible loans.
Retroactive Treatment. Under certain circumstances, a subsidiary that existed prior to REIT election can receive retroactive treatment for the entire fiscal year in which the election occurs.
The “Light Switch” Approach
Fund managers forming new debt funds should consider pre-installing the sub-REIT structure from inception, even before activating REIT status. This approach, sometimes called the “light switch” method, offers two significant advantages. First, building the structure in advance costs substantially less than retrofitting it later. Second, having the subsidiary in place with loans already allocated positions the fund for retroactive treatment when REIT status is eventually elected.
What Does Not Fit in a Mortgage REIT
Certain strategies and asset types are incompatible with REIT status.
Active Trading and Dealer Status
REITs must avoid triggering dealer status under IRS rules. This means loan origination with the primary intent of immediate resale does not work. High-volume loan sales also create problems. Funds designed primarily as gestational vehicles that sell all production to the secondary market are poor candidates for REIT treatment.
However, funds that sell a portion of their production while retaining the majority on their balance sheet can effectively use the sub-REIT strategy to bifurcate qualifying and non-qualifying activities.
Operating Income from Certain Collateral Types
Properties that generate operating income, such as senior housing facilities, hotels, and short-term rentals, require an additional structural layer between the REIT and the property operations. The REIT cannot directly operate these businesses. While most borrowers in these sectors already maintain this operational separation, sponsors should verify the structure before including such loans in the REIT.
Shared Appreciation and Profit Participation Arrangements
Loans structured with rental participation components or equity profit-sharing features do not qualify for mortgage REIT treatment. The REIT should receive only principal, interest, and fees. Hybrid structures combining lending with joint venture participation should be held at the parent fund level.
Practical Considerations for Implementation
Fund Size Thresholds
There is no minimum fund size required to establish a REIT. The relevant question is whether the fund’s operations justify the cost and complexity. As general guidance, fund sponsors should evaluate whether their lending volume supports a fund structure in the first place. Regional benchmarks suggest targeting approximately $5 million in capital raised within the first 12 months for West Coast or East Coast operations, and $2 to $3 million for Midwest markets where average loan sizes tend to be smaller.
Third-Party Administration
Fund managers pursuing the REIT strategy should strongly consider third-party fund administration. Institutional-grade administrators have become increasingly competitive in pricing and have moved down-market to serve mid-sized funds. These administrators provide testing services, compliance monitoring, and operational support that significantly reduce the sponsor’s burden.
A qualified CPA firm experienced in REIT taxation is equally essential. The CPA and administrator work together to ensure all testing obligations are met, typically initiating the review process each March to confirm compliance for the upcoming testing period.
Balance Sheet Lending and Long-Term Strategy
The private lending industry is trending toward greater emphasis on balance sheet strategies. As the secondary market continues to define purchase criteria based on securitization standards, a conforming/non-conforming dynamic is emerging. Lenders who maintain direct lending capabilities through fund structures will be better positioned to serve borrowers whose loans fall outside secondary market parameters.
This long-term trajectory makes the REIT strategy particularly relevant, as funds with staying power will benefit most from the cumulative tax advantages over extended time horizons.
Taking the Next Step
For private lenders evaluating whether a mortgage REIT belongs in their fund structure, the current legislative and market environment presents a favorable window. Whether forming a new fund with the sub-REIT pre-installed or adding the structure to an existing operation, working with experienced legal counsel ensures the implementation is done correctly from the outset.
Geraci LLP has extensive experience structuring mortgage REITs for private lending funds of all sizes. Our corporate and securities team handles the full scope of REIT formation, compliance structuring, and ongoing advisory work.
Contact Geraci LLP today to discuss your REIT strategy:
Phone: (949) 403-3488 Address: 90 Discovery, Irvine, CA 92618 Website: geracillp.com
