The 90% Distribution Rule
The 90% Distribution Rule
The 90% distribution requirement is the cornerstone of REIT legislation. A REIT must pay out at least 90% of its taxable income as dividends to shareholders to qualify for pass-through tax treatment. Fail to meet this threshold and the REIT loses its status, becomes taxable as a corporation, and loses its primary advantage. This single rule shapes every REIT's capital allocation strategy, dividend policy, and growth profile.
Key takeaways
- REITs must distribute at least 90% of taxable income to shareholders annually to maintain tax-pass-through status.
- The distribution can be paid in cash, stock, or a combination, but must occur within a specific time window after year-end.
- Taxable income is calculated differently for REIT purposes than for a regular corporation—it excludes depreciation and certain other non-cash charges.
- The 90% rule means REITs retain little cash for expansion, forcing them to use debt or equity offerings to grow.
- For shareholders, the 90% rule guarantees high dividends but limits reinvestment and internal growth.
What counts as taxable income for REIT purposes
The IRS defines REIT taxable income in a specific way. It starts with net operating income from real estate (rents minus cash operating expenses), adds back depreciation that was deducted for tax purposes, and applies other adjustments. This is different from the taxable income a regular corporation reports. The key point: depreciation, a non-cash expense, is added back into the taxable income calculation. A REIT with strong operating income but high depreciation charges still owes distributions based on the higher taxable income figure.
This creates an interesting dynamic. Many REITs report strong taxable income but lower operating cash flow because depreciation is being added back. When you see a REIT paying a 4% yield, part of that distribution may come from added-back depreciation, not pure cash earnings. This is not a sign of financial distress—it is how REIT accounting works. But it does mean that REIT distributions are not entirely "earnings" in the intuitive sense. Some of the distribution is a return of your own capital.
The distribution frequency and timing
REITs must declare and distribute their dividends at least quarterly, and they must complete the distribution within a specific window (generally by year-end or shortly after). Most REITs pay monthly or quarterly, which is more frequent than typical stock dividends. Some REITs pay special or supplemental distributions if they have extra capital gains. The timing is important: REITs that generate strong cash in Q4 but pay distributions in Q1 of the following year still meet the requirement as long as they declare the distribution within the correct tax year.
Most large REITs pay monthly distributions, which is convenient for investors seeking regular income. Some smaller REITs pay quarterly. The frequency does not affect the total annual payout—it is just a matter of how often you receive checks. For tax purposes, you owe tax on the full annual distribution regardless of how many times it is paid.
How depreciation inflates taxable income
Depreciation is a non-cash expense. When a REIT buys a building for $100 million and depreciates it over 40 years, it deducts $2.5 million per year for tax purposes. That deduction reduces the REIT's net taxable income. But for REIT taxable income calculations, the IRS adds that depreciation back in. The result: a REIT with $100 million in gross rents, $50 million in operating expenses, and $5 million in depreciation charges would report:
Gross income: $100 million Less operating expenses: -$50 million Equals operating income: $50 million Add back depreciation: +$5 million Equals REIT taxable income: $55 million
Required distribution (90%): $49.5 million
The REIT's actual operating cash flow was $50 million, but its distribution obligation is $49.5 million—nearly all of its cash earnings. This is why REITs cannot easily fund growth from retained earnings. They must go to the debt or equity markets.
Why the 90% rule forces leverage and equity dilution
Because REITs must distribute 90% of taxable income, they cannot fund property acquisitions, renovations, or debt repayment from retained earnings. To grow, a REIT must either borrow more money or issue new shares. Most REITs do both. They take on significant leverage (often 40% to 60% of assets financed by debt) and regularly raise equity capital through secondary offerings. This is by design, not by accident.
A private real estate company can reinvest earnings, build cash reserves, and self-fund expansion. A REIT cannot. This shapes REIT behavior: they are forced to be acquisitive and leverage-driven. Over many years, this can lead to overleveraging or poor capital allocation—a REIT that must raise $5 billion in equity capital to make an $8 billion acquisition might overpay to justify the equity issuance. Conversely, the constraint keeps REITs disciplined about capital efficiency and dividend policy.
Tax-deferred accounts vs. taxable accounts
The 90% distribution requirement creates a massive tax drag in taxable accounts. If a REIT yields 4% and you own it in a taxable brokerage account, you owe ordinary income tax on that entire 4% distribution, even if the share price fell that year. By contrast, a stock that gains 4% through price appreciation can be sold and taxed at capital gains rates—or held and deferred indefinitely. Over decades, the tax treatment difference is enormous.
This is why financial advisors recommend holding REITs in Roth IRAs, traditional IRAs, 401(k)s, HSAs, or other tax-deferred accounts whenever possible. The tax benefits of the REIT structure—the pass-through taxation, the leveraged returns, the real estate exposure—are fully realized in tax-deferred space. In a taxable account, the high distributions work against you unless you have specific income needs.
Capital gains and other distribution types
Not all REIT distributions are ordinary income. When a REIT sells a property at a gain, it may distribute some of that long-term capital gain to shareholders. Long-term capital gains are taxed at lower rates than ordinary income. Some REITs also distribute return of capital, which is a return of your own investment and is not taxed (it reduces your cost basis). A REIT's annual distribution statement (Form 1099-DIV) breaks down the distribution into ordinary income, long-term capital gains, and return of capital. Pay attention to these categories when you file taxes. A REIT that generates significant capital gains may be more tax-efficient than one that generates pure ordinary income, even if the total yield is the same.
The 90% rule and REIT valuations
Because the 90% rule limits retained earnings, REITs cannot fund growth from cash flow. This affects how they are valued. Investors should not expect a REIT to grow earnings per share as quickly as a company that reinvests profits. REIT growth comes from property appreciation, operating efficiency, and leverage—not from compounding retained earnings. When a REIT issues new shares to fund growth, earnings per share may grow slowly or even shrink short-term. A REIT growing funds from operations (FFO) by 5% per year while issuing 3% more shares in equity offerings might see earnings per share grow by only 2%. This is normal and expected. It is why many analysts use metrics like FFO per share and net operating income (NOI) to evaluate REIT performance, rather than net income per share.
Decision tree: Is the distribution required?
Next
The 90% rule guarantees that REIT shareholders capture most of the real estate return through distributions. But it also limits the flexibility of REIT management and forces a reliance on leverage and equity markets for growth. The next article explores how REIT ownership compares to direct property ownership—the trade-offs between liquidity, control, taxation, and leverage that make each approach suitable for different investors.