The COVID-19 pandemic came in unexpectedly, and businesses have suffered immensely, with only a few remaining stable despite the economic crisis. REITs have not been spared from the unfortunate repercussions. Therefore, as individuals seek reprieve from the stimulus packages, REITs have also benefitted from the sympathetic direction of the IRS to reduce the distribution temporarily. REITs distribution requirement is not a term that most people are familiar with so let’s tell you what it is and what trusts can do to ensure they still comply during challenging seasons, such as these.
REIT’s Distribution Requirement Definition
Law Insider defines REITs distribution requirement as the amount of dividends sufficient to cover the provision of Section 857(a) of the Internal Revenue code. Another more precise definition is that it is the distribution necessary for a REIT to maintain its status and not pay corporate-level tax based on the income, or excise tax. To retain its status, a REIT must distribute at least 90% of its taxable income. The taxable income, in this case, excludes capital gain and foreclosure income. However, most REITs prefer to distribute more than the 90% distribution requirement to avoid paying tax on the remaining percentage.
The Motley Fool explains that as long as they meet this requirement, the investment trusts are not obligated to pay corporate tax. Therefore this makes it one of the most attractive investments for shareholders since dividends are guaranteed to be high. All the same, the company may enjoy the lack of corporate tax, but shareholders still have to pay income tax in the dividends received. You should note that REITs cannot pass any losses to the shareholders; another advantage that appeals to investors.
While most people assume that the 90% comprise only of the cash distributions, there are usually different types of distributions, and all have different tax rates. So, in the end, the company may not pay tax, but the shareholders cannot escape. The distribution income is in terms of ordinary income, the return of capital and long term gains. Ordinary income distributions result in ordinary dividends, but the REIT can distribute long- term capital gains if it sells a property and shares out the income to shareholders. The main advantage of receiving such is that they are taxed at lower rates than ordinary income distributions. Finally, there is the return of capital when you get to reinvest in the company at a lower cost share price. The difference is an income which you will still pay tax for when you sell your shares.
What If a REIT Cannot Meet the REIT Distribution Requirement?
REIT Mind discusses the two provisions availed to REITs that cannot meet the REIT distribution requirement. Usually, such instances arise if, by the end of December 31st, there is not enough cash to meet the requirements. It could be due to poor planning or anything that comes up unexpectedly that affects the income as the end of the taxable year draws closer. The IRS had the foresight of such scenarios and wrote in the Internal Revenue Code, Section 857 (b) (9) that a REIT can treat dividends declared in the last three months( October, November or December) as paid by the end of the taxable year. That way, the REIT can claim the dividends paid deduction when filing tax returns for that year declared. However, such dividends must be paid in January the following year, and the REIT should not change the amount of dividends that were already declared.
Alternatively, shareholders can report dividends in the year received, and in such a case, the REIT decides on the specific amount to be treated as a dividend distribution. Such a dividend is paid after the end of the taxable year, but for it to be considered, it must be declared before filing the tax return of that taxable year, including extension granted. Additionally, it should be declared before the first regular dividend. Such dividends are therefore referred to as “spillover” or “subsequent” dividends, and Withum gives an ideal example of how they happen. This method, however, has the disadvantage of triggering a non-deductible excise tax of 4%.
Options for Dealing with Inadequate REIT Distribution Income in 2020
Lexology explains that especially in this pandemic season, REITs might find themselves with more taxable income than cash sufficient to meet the REIT distribution requirement. Luckily, besides the IRS provisions, there are other options that the trusts can consider to still comply with this requirement. For instance, they can reduce taxable income in various ways, one of which is carrying forward indefinitely any net operating losses after 2017 taxable year. This method reduces the net taxable income by up to 100% for 2018, 2019 and 2020, and up to 80% from 2021 and beyond. They can also opt to claim bonus depreciation and increases deductions, which in turn will boost the REIT’s cash liquidity.
Private REITs can also declare consent dividends, but not many shareholders would be in favor of this option. Shareholders invest in REITs to make money, and consent dividends make it seem like they have received dividends, yet no cash exchanges hands. A consent dividend is only declared if it would have been included as a shareholder’s income. In such a case, shareholders agree to be treated like they received the cash which was reinvested in the trust. Shareholders have to sign a form that is consequently filed with the tax return and reported in the same year the REIT claims it as a paid deduction.
Some REITs Do Not Follow the Rule
Surprisingly, even though the REIT distribution requirement is considered a rule, Dividend.com stipulates that not all REITs follow it. According to the article, some trusts like Digital Realty Trust and PS Business Parks do not meet this requirement. The explanation is that they do not generate the bulk of the income from property-related ventures, thus making the 90% rule irrelevant. Consequently, it advises such companies to diversify since paying dividends is still essential.
Written by Allen Lee
Read more posts by Allen Lee