Since gaining prominence in private debt fund structures around 2017, Real Estate Investment Trusts have delivered substantial benefits: approximately 20% tax savings through pass-through treatment, UBTI shielding for tax-exempt investors, and state withholding avoidance. These advantages made REITs a cornerstone strategy for sophisticated fund managers.
However, as 2025 unfolds, REIT structures face unprecedented uncertainty. The Tax Cuts and Jobs Act provisions that enhanced REIT economics—particularly the Qualified Business Income deduction—face expiration unless Congress acts. While the current administration supports extension and House passage appears likely, the legislative process creates planning challenges for fund managers.
Even assuming TCJA extension, REIT management presents distinct compliance obstacles that can derail otherwise sound structures. Below are three critical issues fund managers must navigate successfully.
Issue One: Prohibited Dealer Income from Loan Sales
One of the most commonly overlooked REIT compliance requirements involves restrictions on active loan trading. REITs function as passive investment vehicles under tax law—they hold income-producing assets and distribute earnings to investors. This passive character becomes compromised when REITs actively buy and sell loans with intent to profit from trading activity rather than holding for income.
The IRS characterizes income from such activity as “dealer income,” which is prohibited for REIT qualification. When a REIT originates or purchases loans intending to resell them quickly, the IRS may reclassify the operation as a dealing business rather than passive investment, potentially disqualifying the entire REIT structure.
Strategic Solution: Structural Separation
For funds utilizing subordinate REIT structures (SUBREITs), the optimal approach involves routing loan sales through the parent fund entity. The parent fund originates the loan with sale intent, then sells to the third-party buyer, keeping the REIT insulated from dealer income taint.
If a REIT already holds a loan that market conditions now make attractive to sell, transfer to the parent fund for sale may remain permissible—but only when the fund can demonstrate the REIT’s original intent was long-term holding and the sale decision resulted from changed circumstances rather than original dealing intent.
Documentation proving investment intent at origination becomes crucial for defending these positions during IRS examination.
Issue Two: Closely-Held Test Violations
The Internal Revenue Code imposes a critical limitation on REIT ownership: no five individuals may own 50% or more of the REIT on a fully-diluted basis during the second half of each tax year (after the initial year).
This “closely-held” test creates significant compliance obligations that many REITs neglect until violation occurs:
Definitional Complexity
The IRS defines “individual” more broadly than common understanding suggests. The term encompasses:
- Direct individual shareholders
- Lineal descendants (children, grandchildren)
- Lineal ancestors (parents, grandparents)
- Siblings
Family relationships that appear to create diverse ownership may actually concentrate ownership under IRS attribution rules.
Testing Requirements
Compliance demands quarterly ownership analysis—not annual or casual monitoring. Ownership percentages shift as:
- New investors join
- Existing investors redeem
- Family members transfer interests
- Economic participation changes through profits allocations
Proactive Protection
Properly drafted offering documents should grant fund managers explicit authority to force redemptions when necessary to maintain REIT qualification. Without this contractual power, managers may lack legal recourse when ownership becomes dangerously concentrated.
For SUBREIT structures, remember: the closely-held test examines the parent fund’s ownership, not just the REIT subsidiary. Managers must monitor the complete cap table quarterly to maintain compliance.
Issue Three: Insufficient Distribution of Taxable Income
REITs must distribute at minimum 90% of taxable income to shareholders. This seemingly straightforward requirement creates complex accounting challenges that can result in unexpected tax disqualification.
Accounting Complications
The distribution requirement depends on accurate taxable income calculation, which may differ materially from financial accounting income. Particular challenges arise from:
Defaulted Loan Treatment: How does the REIT account for loans where payment has ceased but foreclosure hasn’t completed? Different accounting methods produce different taxable income results.
Valuation Allowances: Marking loan portfolio to market value may create financial statement losses that don’t correspond to taxable income calculations.
Loss Reserves: Conservative reserving for potential losses affects financial results but may not align with tax income computation.
CPA Expertise Requirement
Given these complexities, REIT compliance demands experienced tax accounting professionals who understand the distinction between book income and taxable income. Generic accounting support insufficient—the CPA must bring specific REIT expertise to ensure accurate taxable income calculation and appropriate distribution amounts.
SUBREIT Advantages
Subordinate REIT structures offer distribution flexibility unavailable to standalone REITs. The SUBREIT can distribute 100% of taxable income to the parent fund, providing cushion against calculation errors while the parent fund manages investor distributions based on cash flow and business considerations rather than rigid tax requirements.
However, even with SUBREITs, the closely-held test still applies at the parent level, requiring continued ownership monitoring.
Strategic Outlook: REITs in the Post-TCJA Landscape
Fund managers face critical strategic decisions as tax policy evolves. If TCJA provisions sunset without replacement, the economic advantage of REIT structures diminishes substantially—though not entirely. Even without QBI deductions, UBTI blocking and state withholding avoidance retain value for funds with tax-exempt or non-resident investors.
Managers should:
- Model Both Scenarios: Quantify REIT benefits under current law versus post-sunset alternatives
- Monitor Legislation: Track TCJA extension progress and prepare for multiple outcomes
- Maintain Compliance: Regardless of tax policy uncertainty, existing REITs must maintain perfect compliance with all three requirements discussed above
- Document Thoroughly: Support all operational decisions with clear documentation proving compliance intent
Conclusion
REIT structures remain powerful tools for private debt funds, but only when managed with rigorous attention to compliance requirements. Loan sale restrictions, ownership concentration limits, and distribution obligations each present distinct challenges requiring proactive management.
Combined with evolving tax legislation, these compliance demands make experienced legal counsel essential for fund managers utilizing or considering REIT structures. The benefits remain significant—but only for those who implement correctly and maintain vigilance.
For comprehensive guidance on fund formation, REIT structures, and securities compliance, contact Geraci LLP’s Corporate & Securities Department.
