Real estate investment trusts (REITs) are an attractive entity type due to their preferential tax treatment and the many benefits offered to investors. However, to receive this preferential tax treatment, REITs must meet numerous tax requirements throughout the year, both quarterly and annually. One of the annual requirements is that a REIT must distribute 90 percent of taxable income to its investors each year. If a REIT does not meet this distribution requirement, its status as a REIT could be jeopardized and taxes imposed on its undistributed taxable income.
Given the ongoing economic challenges due to COVID-19, specifically to the hard-hit rental real estate industry, annual taxable income may not always be indicative of current cash flow available for distributions. In these situations, it is possible that a REIT will be unable to meet its 90 percent distribution requirement in the current tax year. However, there are three tax provisions available for REITs to remedy being under-distributed without generating a current year REIT tax liability:
- Consent dividends (IRC Section 565)
- Subsequent year dividends, also known as spill-over dividends (IRC Section 858)
- Year-end dividends (IRC Section 857(b)(9))
Let's take a closer look at these three options.
||Consent Dividends Consent dividends are dividends that are deemed to have been paid by a REIT to its investors without cash actually exchanging hands. These dividends are treated as if paid to investors on the last day of the tax year and immediately contributed back to the REIT. The primary advantage of this option is that a REIT does not have to disburse any cash while still meeting its annual distribution requirement. Consent dividends are declared on the REIT's tax return and require special reporting on Forms 972 and 973. While consent dividends seem convenient and easy to report, there are drawbacks. While the REIT includes the Form 973 with its tax return, all shareholders are required to sign a Form 972 for the consent dividends to be effective, and the consent dividends are taxable to shareholders as if they were received in cash.
||Subsequent Year Dividends Subsequent year dividends, also known as spill-over dividends, allow a REIT to treat a dividend paid in a subsequent period as paid in the previous period. These dividends must be declared before the due date (including extensions) of a REIT's tax return. This dividend payment does not need to be the first dividend declared in the subsequent year, so long as any dividend declared prior to the declaration of the subsequent dividend is paid first. Even though this dividend is credited towards the dividends paid deduction of a prior year, the shareholder will recognize the dividend income in the year it was received. While this dividend payment helps achieve the distribution requirements for REITs, there is potential excise tax exposure to disincentivize the excessive use of the subsequent year dividends. The excise tax is equal to four percent of the excess of the "required distribution" over the "distributed amount" (IRC Section 4981).
||Year-End Dividends The year-end dividend allows a REIT to declare a dividend in October, November or December, and the distribution will be deemed as paid by December 31 of the current taxable year, so long as the distribution is actually paid by the end of January the following year. These dividends offer the REIT some flexibility from a cash flow perspective while continuing to meet their distribution requirements for the taxable year. From a shareholder perspective, they will report the income in the year the dividend is declared and receive the cash in the next year.
As year-end quickly approaches, REIT management teams should plan today for tax distribution requirements. Reach out to your tax advisor or DHG to speak with our industry professionals to discuss your year-end tax planning questions.