What if Your REIT Doesn’t Meet Its Distribution Requirement?
June 17, 2020
Real Estate Investment Trusts (“REITs”) provide numerous benefits to a variety of investors, but the rules are specific and can be complex. One benefit of a REIT, as opposed to other taxable corporations, is that you can deduct up to 100% of its taxable income in the form of a dividends paid deduction. Correspondingly, one of the aforementioned rules for an entity to be REIT-compliant is the distribution requirement. A REIT is required to distribute 90% of its taxable earnings—even though most REITs will distribute at least 100% of their taxable earnings to fully utilize the dividends paid deduction and not have corporate income tax. But what happens if the REIT fails to meet the distribution requirement? Are there any remedies?
Dividends must be pro rata and without “preference” within a single class of stock. However, REIT dividends can be preferential between different classes of stock when one class of stock has preference over the other. There are three provisions that will remedy the situation when a REIT fails to meet its distribution test:
- Declare the dividend in the current tax year and pay in January of the subsequent year.
- Declare and pay the dividend in the subsequent year.
- Declare a consent dividend.
Declare the Dividend in the Current Tax Year and Pay in January of the Subsequent Year
If a REIT declares a dividend in Q4 of a taxable year (October, November, December) to shareholders of record in such quarter, but does not pay the dividend until January of the following year, the distribution is deemed to have been paid on the last day of the taxable year (i.e., December 31.) The REIT will include the distribution in the current taxable year; however, the shareholder will need to also include the dividend in their taxable income for the current tax year. These dividends are deemed paid on the last day of the taxable year. The REIT must have earnings and profits in the tax year in order to classify these distributions as dividends.
Declare and Pay the Dividend in the Subsequent Year
If a REIT does not declare the dividend in the prior tax year, there is still a remedy. The REIT can deduct dividends in the prior tax year if the dividend is declared prior to the due date of the REIT’s tax return, including extension, and the dividend is paid in the 12-month period following the close of the REIT tax year. Once the dividend is declared with regard to the prior tax year, it must be paid no later than the next regularly scheduled dividend.
For example, assume that a REIT typically makes distributions on June 30 and December 31 each year. On May 15 of the current year—the year subsequent to the tax year—the REIT declares a dividend related to the prior tax year to solve its distribution requirement. The dividend related to the prior tax year must be distributed no later than June 30. The distribution must be from the earnings and profits of the prior tax year. Under this scenario, the REIT will deduct the dividend in the prior tax year; however, the shareholder will be taxed on the REIT in the year in which it was paid. This option may cause the REIT to be subject to the excise tax for the prior tax year.
Declare a Consent Dividend
A “consent dividend” is a constructive distribution from the REITs earnings and profits. From a shareholder’s perspective, it is treated as a taxable dividend on the federal income tax return in the current year. It is considered as if the shareholder immediately reinvested the dividend back into the REIT, increasing the paid-in capital of the REIT and increasing the shareholders basis in the REIT stock. This will allow the REIT to keep the cash in the REIT and increase the shareholders’ investment in the REIT. All shareholders must consent to the dividend by completing and signing Form 972, and the REIT will complete Form 973. Both forms must be submitted with the REIT’s tax return and by the REIT’s tax filing due date, including extensions. If a shareholder does not consent and is not distributed cash, then there is a preferential dividend with regard to the class of stock having the consent dividend, and no amounts with regard to that stock are eligible for the dividends paid deduction.
None of the Above
If a REIT fails to meet the distribution requirement and does not elect one of the three aforementioned solutions, it will fail to be a REIT and will be taxed as a C corporation. Some practitioners believe if an entity continues to pass all other REIT requirements, the REIT will be taxed as a REIT in the subsequent tax year. Others view that the five-year prohibition on re-election applies, and the REIT will be taxed as a C corporation for the five-year period. Given the uncertainty of the application of this rule, it is critical for a REIT to meet its dividend distribution requirement.
A REIT should also be aware of potential state and local tax issues. While some jurisdictions comply with federal law for REITs, some do not, specifically regarding consent dividends. This could cause the REIT to have an income tax liability in state and local jurisdictions, even if there is no federal taxable income. State adjustments can also cause a REIT to have state income and, therefore, state income tax liability. Furthermore, some states have a franchise, excise, or net worth tax to which the REIT will be subject.
A best practice is to monitor the REIT’s estimated taxable income and distributions paid throughout the year in order to comply with REIT distribution requirements and avoid a potential shortfall. An essential part of REIT compliance is ensuring the REIT meets distribution requirements. If there is a deficiency in the REIT’s distributions at year-end, contact your tax advisor to discuss and assess your best options to ensure the REIT’s compliance with the distribution requirement.