ACCA Advanced Financial Management (AFM) Practice Exam

What key condition allows REITs to avoid taxation?

1. They must generate high capital gains

2. They require a broad investment portfolio

3. They need to distribute a significant percentage of earnings

4. They must have a limited number of shareholders

The correct answer is: They need to distribute a significant percentage of earnings

Real Estate Investment Trusts (REITs) avoid taxation at the corporate level due to a key requirement to distribute a significant percentage of their earnings to shareholders, typically at least 90% of their taxable income. This regulation is rooted in the intent to encourage investment in real estate and provide a stream of income to investors. By distributing a large portion of their income, REITs effectively pass on the tax liability to the shareholders who then pay taxes at their individual tax rates. This mechanism promotes investment in real estate by creating a tax-efficient structure that can attract more capital. Investors benefit since they receive income through dividends, and the REITs benefit by maintaining their tax-exempt status, allowing them to focus on growth and reinvestment in their properties. The other conditions do not reflect the fundamental requirement needed for tax avoidance by REITs. High capital gains are advantageous but not a requirement for tax status. A broad investment portfolio is typically a characteristic of diversified investment entities, but it is not a primary condition for REITs. Having a limited number of shareholders does not align with the public nature and accessibility that REITs are designed for, as they usually require a substantial number of shareholders to qualify as a publicly traded entity.