ACCA Advanced Financial Management (AFM) Practice Exam

How are real estate investment trusts (REITs) generally taxed?

1. Taxed on total income

2. Not taxed if they distribute 95% of earnings

3. Taxed only on capital gains

4. Exempt from taxes under all circumstances

The correct answer is: Not taxed if they distribute 95% of earnings

Real Estate Investment Trusts (REITs) generally benefit from a favorable tax treatment under specific conditions. To qualify for this treatment, REITs must distribute at least 90% of their taxable income to shareholders in the form of dividends. This distribution requirement allows them to avoid taxation at the corporate level, effectively making the REIT a pass-through entity for tax purposes. When a REIT meets the distribution requirement, it is not subjected to federal income tax on the earnings it distributes, which leads to a significant tax advantage. This structure encourages investment in real estate as it provides investors with income without the double taxation commonly associated with corporate income (taxed at the corporate level and again at the shareholder level when distributed as dividends). In contrast, the other options do not appropriately reflect the taxation principles applicable to REITs. For example, while some forms of income are taxed differently, the specific requirement for REITs to distribute the majority of their earnings to avoid taxation is what sets this investment vehicle apart.