Real Estate Investment Trusts (REITs) can provide numerous benefits to a variety of investors looking to invest in real estate, but fund managers must be conscientious of the rules that come with using a REIT. Among the many requirements to qualify as a REIT, which are outside of the scope of this article (see The ABCs of REITs for details), a REIT is required to distribute at least 90% of its taxable income in each taxable year. If a REIT distributes less than 90%, REIT status could be compromised and taxes might apply. Fortunately, there are remedies available to a REIT that determines it is under-distributed. The following provisions may help a REIT meet its 90 percent distribution requirement:
- Declaration of dividends before end of taxable year, paid in a subsequent year
- Declaration and payment of dividends in the subsequent year
- Consent dividends
Dividends declared before end of taxable year and paid in subsequent year
If a REIT declares a dividend in October, November or December of a taxable year and the dividend is paid to the shareholders of record in January of the following year, the distribution may be treated as paid Dec. 31 of the current year for purposes of meeting the 90% distribution requirement for the current year. The inclusion of the dividend as a REIT distribution in the year declared rather than paid also means that the REIT shareholders need to recognize that dividend in the year declared. These distributions are only deemed paid by Dec. 31 to the extent that the REIT’s earnings and profits for the year exceed actual distributions paid. Any amounts paid in January that are not deemed paid on Dec. 31 are recorded as distributions paid by the REIT and received by the shareholders in the year of payment.
Declared dividends after end of taxable year
A REIT can elect to include a specific amount of distributions declared and paid in the following year as paid during the current taxable year in order to meet its distribution requirement. This is permitted as long as the REIT declares a dividend before the due date of the filing of the tax return, including extensions, and the dividend is paid to the shareholders within the 12 months after the year but no later than the date of the first regular dividend payment. If a REIT uses this option, it should be aware of the distribution requirements for the following taxable year as there could be increased risk of an excise tax. The excise tax is 4% of the amount by which the actual distributions for the year fall short of the required distributions. Shareholders must recognize the dividend in the year received.
A REIT may also elect to report a consent dividend for the remaining excess earnings and profits, which is a dividend that is not actually paid to its shareholders but deemed paid for purposes of the distribution test. A REIT declares a consent dividend by filing Form 973 with its tax return. The distribution is deemed to be distributed to shareholders on the last day of the taxable year and then contributed (as additional paid-in capital) back on the same day. Since a consent dividend is taxable to the shareholders even though they did not receive the cash, the shareholders must consent to that inclusion by completing Form 972 and providing to the REIT. The deemed distribution must be made in the same proportion of each shareholder’s common stock ownership to avoid any preferential dividend issues.
It is best practice for a REIT to track its estimated taxable income and distributions paid throughout the year in order to evaluate a potential shortfall well before year-end. A REIT must also evaluate state implications for these remedies as not all states follow these rules. If a deficiency is found, it is prudent for the REIT to contact its tax advisor and assess its options to meet the distribution requirement. Confirming a REIT is sufficiently covered for the distribution requirement is a critical step in maintaining REIT status along with the other yearly requirements; so significant steps should be taken to make sure this has been met or will be met in a different way to avoid any substantial tax payments owed.