How REITs can determine the start of the two-year holding period for the “production of rental income."

A Real Estate Investment Trust (REIT) is designed to be a passive investment vehicle, with most of its income derived from real property rents or interest from mortgages on real property.

While REITs sell or dispose of real property at various times, frequent sales activity is not consistent with their intended passive nature. A 100% tax is imposed on net income from a “prohibited transaction,” defined as a sale of property which is held primarily for sale to customers in the ordinary course of a trade or business (Code Sections 857(b)(6)(B)(iii); 1221(a)(1)).

If sales of property fall within a safe harbor, they will not be deemed to be a prohibited transaction (Code Section 857(b)(6)(C). Besides a limitation on the number of sales that a REIT can have within a given year, the following criteria must be met to be covered under the safe harbor:

(i)            The property must be real property,

(ii)           Capital expenditures made by the REIT (or any partner thereof) within two years of sale cannot exceed 30% of the net sales price, and

(iii)          With respect to property that consists of land or improvements, the REIT has held the property for not less than two years for the production of rental income.

Production of Rental Income

With respect to requirement (iii) above, the term “the trust has held the property for not less than two years for the production of rental income” is not defined in the Code, Regulations, Revenue Rulings, Private Letter Rulings, or court decisions. Lacking clear guidance, it is likely that the term “held for the production of rental income” will be interpreted similarly to an analysis pursuant to “placed in service” principles for the commencement of depreciation. This standard requires that property must be in a current condition to produce current rents/occupancy, continuously marketed as available in that condition, and all legal requirements for occupancy have been satisfied. If the property is being developed or redeveloped and advertised for future rents/occupancy, it does not meet this standard.

In addition, a Certificate of Occupancy (CO) is generally legally required in order for a tenant to move into the premises; however, it is possible that the two-year holding period necessary to satisfy the holding for the production of income standard may begin prior to issuance of a CO if the facts show that a lease was signed, and the space is available and ready for the tenant to occupy.

The legislative history accompanying the passage of this section provides that the renting of property at an insignificant rate of rental or for a use that indicates that the purpose of the rental arrangement was not for the production of rental income will be disregarded. (S. Rep. No. 1263, 95th Cong (1978)).


Company A, a REIT, purchased property that has a current CO and, when purchased, was marketed to office tenants, which the CO allowed. Company A was unsuccessful in securing an office tenant and chose to significantly upgrade the property for a specialized space and change the zoning to allow such use. As the term “held for the production of rental income” is not clear, there are several dates that need to be evaluated to determine when the holding period should begin:




June 2018

Purchase real property and market for lease to office tenant

May–September 2019

Determination that there was no real interest by office tenant in the current condition the property was in, façade work was started.

December 2019

Zoning was changed to permit more than 50% use of the space for a specialized use.

March 2020

Lease signed by office tenant (Tenant 1) for 46% of space.

May 2020

Façade, exterior and lobby improvements are completed.

June 2020

Lease signed for a specialized use (Tenant 2) for 54% of space.

July 2020

Tenant 1 lease commences. Work in Tenant 1’s space is completed, and building can be occupied.

June 2021

Tenant 2 lease commences. Work in Tenant 2 space is completed.

Under the placed in service principles, the start of the two-year holding period should be the date of availability for occupancy by Tenant 1. Assuming the space is available for occupancy by Tenant 1 in July 2020, it is more likely than not that the two-year holding period begins on this date, even though it is possible that a CO might not have been issued. To satisfy the safe harbor outlined above, Company A would be advised not sell this property prior to July 2022.

Please contact your Mazars’ REIT Practice professionals for additional information.


Aditya Bhutoria
Bonni Zukof, Senior Manager 
Howard Landsberg, Partner 

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.