How can REITs avoid paying income tax?

Real Estate Investment Trusts (REITs) avoid paying federal income tax by distributing at least 90% of their taxable income to unit holders in the form of dividends. This distribution requirement is crucial because it allows REITs to qualify for a special tax treatment under the Internal Revenue Code. By adhering to this rule, REITs effectively pass their income through to investors, who then pay income tax on the dividends received instead of the REIT itself facing a tax liability.

This structure is significant in the context of REITs, as it encourages investment in real estate and provides investors with a reliable income stream. The requirement to distribute a large portion of their income is designed to ensure that the REITs operate with a focus on returning value to their investors rather than accumulating retained earnings.

The other options do not relate to the specific strategy utilized by REITs to avoid income tax. Investing in international real estate, using tax loopholes, or limiting investments to commercial properties does not inherently qualify a REIT for tax-exempt status. Only the mandatory distribution of the majority of income to shareholders allows REITs to maintain their favorable tax treatment.