Why Private Real Estate Funds Use a REIT Inside the Structure

Most investors think of a REIT as a ticker symbol: a listed company that owns office towers, apartments, or cell towers and pays a dividend. That is only part of the picture. Nareit estimates that listed and non-listed, public and private REITs together hold more than $4.5 trillion of real estate assets, and a meaningful share of that sits inside private vehicles that never trade on an exchange.¹

For a private real estate fund, a REIT is less a product than a tax wrapper. Sponsors place a REIT between the fund and its properties or loans because the wrapper changes how income reaches the investor. Depending on who the investor is, that change can remove tax filing headaches, eliminate exposure to unrelated business income, or lower the effective federal rate on distributions.

This article walks through how the structure works, who benefits most, and what a sponsor has to do to keep REIT status intact. It is written for investors evaluating private funds and for operators weighing whether a REIT belongs in their own structure.

The Basic Mechanics

A typical private fund is organized as a limited partnership or LLC taxed as a partnership (see our comparison of a real estate fund vs. syndication). Income, gains, and losses flow through to each investor on a Schedule K-1, and each investor reports their share as if they earned it directly.

When a REIT is inserted, the fund (or the investors directly) own shares of the REIT, and the REIT owns the real estate or the loans. The REIT is a corporation for tax purposes, but it receives a deduction for the dividends it pays. If it distributes all of its taxable income, it pays little or no corporate tax. Investors receive dividends reported on Form 1099-DIV rather than a share of rents, interest, and depreciation on a K-1.

That conversion, from pass-through operating income to dividend income, is where most of the benefits come from.

The Rules a REIT Has to Follow

REIT status is earned every year by satisfying a set of organizational, income, asset, and distribution tests in Sections 856 and 857 of the Internal Revenue Code. The main ones are:

Requirement	What the Code requires
Ownership breadth	Beneficial ownership held by 100 or more persons for at least 335 days of a 12-month taxable year2
Not closely held	Five or fewer individuals may not own more than 50 percent of the value of the shares during the last half of the year2
75 percent income test	At least 75 percent of gross income from real estate sources such as rents from real property and interest on obligations secured by real property2
95 percent income test	At least 95 percent of gross income from the 75 percent sources plus other passive sources such as dividends and interest2
75 percent asset test	At least 75 percent of total assets held in real estate assets, cash and cash items, and government securities, tested at each quarter end2
TRS limit	No more than 25 percent of total assets in securities of taxable REIT subsidiaries (raised from 20 percent for tax years beginning after 2025)23
Distribution	Dividends of at least 90 percent of REIT taxable income each year4

Two practical notes are worth adding. First, the 100-shareholder and closely-held tests do not apply in a REIT’s first taxable year, which gives a new vehicle time to build its shareholder base.² Second, most REITs distribute close to 100 percent of taxable income rather than the 90 percent minimum, because any retained income is taxed at the corporate level and a 4 percent excise tax applies if distributions fall short of certain calendar-year thresholds.⁵

Private sponsors commonly satisfy the 100-shareholder test by issuing a small class of preferred shares to a broad group of holders. Specialized administrators provide this service for a modest fee, and it is a routine part of private REIT formation.

The Service Income Problem and the TRS Fix

REITs are meant to be passive. Rents qualify for the income tests, but income from services provided for a tenant’s convenience (beyond what is customary for the property type) can fail to qualify, and if those impermissible services exceed a small threshold at a property, they can taint all of the rent from that property.

The standard solution is a taxable REIT subsidiary, which is a regular C corporation owned by the REIT that can provide non-customary services, run operating businesses, and earn fee income without jeopardizing REIT status. The TRS pays corporate tax on its own income. Under the One Big Beautiful Bill Act, the share of REIT assets that can sit in TRS securities increased to 25 percent beginning in 2026, restoring the limit that applied before 2018.³

For operators in hands-on asset classes, this matters. RV parks, campgrounds, and manufactured housing communities often involve amenities, short-term stays, utility billing, and home sales, all of which need to be mapped against the REIT income rules before the structure is finalized. That analysis belongs with tax counsel early in the process, not after the first year’s returns.

Who Benefits, and How

Tax-exempt investors

Pension plans, endowments, foundations, and IRAs are generally exempt from federal income tax, but they pay tax on unrelated business taxable income (UBTI). Two common sources of UBTI in real estate funds are income from debt-financed property and income from operating businesses held through a partnership.

Dividends are specifically excluded from UBTI.⁶ Because a REIT pays dividends, a tax-exempt investor holding REIT shares (without borrowing to buy them) generally receives clean, non-UBTI income even if the REIT itself uses leverage. One exception to watch: a “pension-held REIT,” where qualified pension trusts own a dominant share of the vehicle, can pass a portion of UBTI through to those pension investors, so sponsors raising heavily from pension plans should model ownership concentration.²

The Tax Cuts and Jobs Act made this more valuable. Under Section 512(a)(6), a tax-exempt organization must now compute UBTI separately for each unrelated trade or business, and losses from one activity can no longer offset income from another.⁶⁷ Before that change, an investor could net a loss from one fund against a gain in another. Now each silo stands alone, which makes a structure that avoids UBTI entirely more attractive than one that tries to manage it.

Foreign investors

Non-U.S. investors in a partnership that operates U.S. real estate, or that regularly originates loans in the U.S., can be treated as engaged in a U.S. trade or business. That creates effectively connected income (ECI), which brings U.S. tax filing obligations and withholding. Practitioners note that the IRS views regularly making loans to the public in the U.S. as a financing business, which is the core ECI concern for foreign investors in private credit funds.⁸

A REIT acts as a blocker. The REIT, not the foreign investor, conducts the business. The investor receives dividends, which are subject to withholding (often reduced by treaty) but generally do not require the investor to file a U.S. return on the underlying operations. The final OBBBA also dropped the proposed Section 899 “retaliatory tax,” leaving existing treatment of foreign REIT investors in place.³

U.S. taxable investors

Historically, U.S. individuals gave something up with a REIT: depreciation and losses no longer flowed through on a K-1. Section 199A changed that trade-off. Individuals may deduct 20 percent of qualified REIT dividends, and unlike the deduction for directly held business income, the REIT component is not limited by W-2 wages or the basis of qualified property.⁹ At the top bracket, that brings the effective federal rate on ordinary REIT dividends to 29.6 percent instead of 37 percent.³

Section 199A was scheduled to expire after 2025. The One Big Beautiful Bill Act made it permanent, removing the sunset risk that had made sponsors hesitant to build around it.³

There is also a state tax benefit. A partnership investor may receive a K-1 showing income in every state where the fund owns property, and may need to file nonresident returns or accept composite withholding in each. A REIT files where it does business, and its shareholders generally report dividends only in their state of residence.

The Administrative Case

Even investors who are indifferent to the tax mechanics tend to appreciate the paperwork. Partnership K-1s are frequently late because the fund cannot finalize its own return until it receives K-1s from every underlying entity. Investors in several funds often file extensions every year as a result. REIT investors receive a Form 1099-DIV on the normal schedule.

For the sponsor, the REIT adds real work: quarterly asset testing, annual income testing, distribution planning, shareholder record keeping, and a separate corporate return. In most institutional structures that cost is small relative to the benefit, but it is a real line item, and a sponsor should budget for an administrator and a tax advisor who handles REITs regularly.

Why This Fits Private Credit Especially Well

Most discussion of private REITs focuses on equity funds that own buildings. The structure fits a first-lien debt fund just as naturally, and in some ways more cleanly.

Interest on obligations secured by mortgages on real property counts toward the 75 percent income test, and those mortgage loans count as real estate assets for the 75 percent asset test.² A fund that originates first-lien bridge loans on real property is already doing the kind of business the REIT rules were written for. The tenant-services issue that complicates operating real estate largely falls away, because a lender is collecting interest, not providing services to occupants.

At the same time, the investor benefits are pronounced for a credit strategy. Interest income in a partnership is ordinary income taxed at full rates, so the 199A deduction on REIT dividends is a direct improvement for U.S. individuals. Lending is also the activity most likely to create ECI for foreign investors, which a REIT blocks. And debt funds that use a credit facility to enhance returns can create debt-financed UBTI for tax-exempt partners, which the REIT dividend structure avoids.

How We Structured the Requity Income Fund: The Sub-REIT

We built this structure into our own vehicle using what the industry calls a sub-REIT. A sub-REIT is a private REIT that sits underneath a fund, while the fund itself stays a limited partnership. Investors never hold REIT shares directly. They invest in the fund, and the fund owns the REIT.

For the Requity Income Fund, the structure has been live since April 2026 and works in three layers:

• Investors hold limited partnership interests in Requity Income Fund LP, a Delaware limited partnership offered under Rule 506(c) to verified accredited investors.
• The fund owns the common equity of the sub-REIT and sets the investor-facing terms: the target return, monthly distributions, and the option to reinvest.
• The sub-REIT holds the qualifying first-lien real estate loans from the portfolio, collects the interest, and pays it up to the fund as qualified REIT dividends.

Because the fund counts as a single shareholder, a sub-REIT cannot meet the 100-shareholder test through the fund alone. The standard solution is a small class of preferred shares issued to roughly 125 outside holders, which satisfies the test without changing the economics for fund investors.¹⁰ The closely-held test, by contrast, looks through the fund to the ultimate owners, so a fund with a broad investor base generally clears it naturally.¹⁰

Why sub-REITs are becoming the preferred design

Sponsors increasingly choose a sub-REIT over a standalone REIT because it captures most of the tax benefits while keeping the flexibility of a partnership at the top. In practice that flexibility shows up in several ways.

First, the fund keeps partnership economics. Distribution policy, preferred returns, reinvestment elections, capital accounts, and admissions and redemptions are governed by the limited partnership agreement rather than by the corporate rules a REIT would impose on its own shareholders. That lets a sponsor design investor terms around the strategy instead of around REIT mechanics.

Second, not every asset has to live inside the REIT. The REIT income and asset tests apply only to what the sub-REIT holds. Assets that fit the REIT rules cleanly, such as first-lien mortgage loans, go into the sub-REIT, while anything that does not fit can be held at the fund level or in a separate entity without putting REIT status at risk. For a lender, that means the core loan book benefits from REIT treatment while the fund retains room to pursue opportunities that fall outside the REIT tests.

Third, the structure can evolve with the investor base. As a fund adds IRA, tax-exempt, or international capital, the sponsor can adjust what sits inside the sub-REIT, or add another one, without asking existing investors to exchange their interests for a new security.

Fourth, the tax benefits still reach investors. Qualified REIT dividends keep their character when they pass through a partnership, so U.S. individual investors can still apply the Section 199A deduction to income from the sub-REIT.⁹ For a strategy whose returns come almost entirely from interest, that is a meaningful improvement in after-tax yield. The UBTI and ECI protections described above also apply to the activity conducted inside the sub-REIT, which is why sponsors generally keep borrowing and lending activity within the REIT rather than at the fund level.

The trade-off is that investors still receive a Schedule K-1 from the fund rather than a Form 1099-DIV, and the sponsor maintains two layers of compliance: partnership reporting at the fund and REIT testing at the sub-REIT. For us, keeping the flexibility of a partnership was worth that added administrative work, particularly as our investor base increasingly includes self-directed IRAs and other tax-sensitive capital.

Trade-offs to Weigh

A REIT is not right for every fund. Sponsors and investors should consider a few points:

• Losses do not pass through. In a value-add or development strategy with large early depreciation or operating losses, U.S. taxable investors lose the ability to use those losses on their own returns.
• Distribution requirements reduce flexibility. A REIT that wants to retain capital for reinvestment pays corporate tax on what it keeps.
• Compliance failures are expensive. Missing an income or asset test can trigger penalty taxes or, in serious cases, loss of REIT status, so the tests need to be monitored continuously rather than at year end.
• Formation and administration add cost, particularly for smaller vehicles.

For funds with a meaningful share of tax-exempt, IRA, or foreign capital, or funds that expect institutional allocators to require it, those trade-offs usually favor the REIT. For a small, purely domestic, loss-generating equity strategy, a straight partnership may still be the better fit.

The Bottom Line

The REIT is one of the most flexible tools available to a private real estate sponsor. It turns rents and mortgage interest into dividend income, which removes UBTI for tax-exempt investors, blocks ECI for foreign investors, and gives U.S. individuals a permanent 20 percent deduction under Section 199A. In a standalone REIT, it also simplifies investor tax reporting by replacing late K-1s with timely 1099s, and in a sub-REIT design like ours it improves the character of the income investors receive while preserving the flexibility of a partnership at the fund level.

As private real estate and private credit continue to draw capital from IRAs, pensions, family offices, and international investors, expect more sponsors to build a REIT into the structure from day one, and expect more sophisticated investors to ask for one.

This article is for educational purposes only and is not tax, legal, or investment advice. REIT qualification and investor-level tax consequences depend on specific facts. Consult your own tax and legal advisors.

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