Real Estate Investment Trusts (REITs), just like 99.9% of all other industries, are feeling the pain from the COVID-19 impact. Many REIT stocks are trading at 52 week lows. On the positive side, this is not 2008. REITs have stronger balance sheets, with leverage near historical lows, maturities have been staggered, REITs have access to low-cost debt capital, and the business mix of REITs has become less cyclical.
Turning the tables, REITs provide space to many industries heavily impacted by the COVID-19 social distancing measures such as travel, tourism and retail. Many retail tenants were struggling before the pandemic, office leasing may slow, and net leases prove to be uncertain right now.
In addition, REITs are in a bit of a unique situation. Actions they chose to take in response to COVID-19, need to stay in compliance with REIT tests under the tax laws.
- A REIT must have at least 95% of its gross income derived from certain qualifying income sources, and at least 75% of its gross income derived from real-estate related sources. Gross income tests are usually measured on a quarterly basis to ensure compliance.
Planning Tip: Start forecasting significant changes to qualifying and non-qualifying income for the remainder of 2020 now. This allows any gross income problems to be identified early, and a method to correct them enacted.
- In today’s current market REITs need to be careful acquiring certain assets. Why? REIT rules say that value means “fair value as determined in good faith by the trustees.” Many REITs also simply use their generally accepted accounting principles (GAAP) balance sheets as the appropriate valuation for asset testing purposes. Many REITs are trading at 52 week lows, and each REIT must use its own judgement about how to value its assets.
Planning Tip: Acquiring certain assets, inclusive of those pursuant to contractual purchase obligations and operating partnership unit redemptions, may cause a REIT to lost the benefit of grandfathered asset test qualification.
- Americans are out of work, and looking for ways to find relief. One of the ways they do this will be asking for relief on rental payments. “Sorry, I can’t pay you this month” is becoming a widely used phrased. Whether it be through deferrals of payments, reductions in payments, or deferrals that end up being reductions, REITs need to be careful providing relief. When making amendments to leases REITs can turn qualifying income into non-qualifying income.
Planning Tip: Make sure you test relief to tenants under the asset and income tests. There are restrictions such as receiving rent that is based in whole or in part on the net income of profits of the tenant, and taking a 10% or greater ownership interest in the tenant.
- Savings Provisions. During hard times, REITs may need to engage in unusual transactions, with uncertain tax consequences. A REIT can “save” its REIT status by paying a penalty tax. The REIT Savings provision requires that a REIT act with “reasonable cause and not due to willful neglect.”
Planning Tip: If you are unsure about a tax consequence from a particular transaction, you may want to seek a written opinion from legal counsel to establish reasonable cause.
- Distribution Requirements. Outside of net capital gains, REITs generally distribute 90% of their net taxable income annually. However, we are living in a pandemic and the conservation of cash is key, so the disbursement of cash can actually be more of a burden than the corporate income tax.
What happens if you have more net taxable income than cash available for distribution in 2020?
- Reduce Taxable Income
- Carryforward post-2017 net operating losses indefinitely, to reduce up to 100% of the REITs net-taxable income in 2018 through 2020, and up to 80% of the REITs net taxable income in 2021 and later.
- Qualified Improvement Property placed in service in 2018 and later is now eligible for bonus depreciation under the CARES Act. Therefore, QIP placed in service in 2018 through 2022 may be fully deductible for federal income tax purposes.
- If you are a REIT that has elected out of 163(j) you may still claim bonus depreciation on tangible personal property with a class life of less than 20 years, and depreciate your qualified improvement property placed in service in 2018 and later over a shorter 20-year recovery period (instead of 40 years before the CARES Act).
- Pursue cost segregation studies for properties which may have significant short-lived assets on which bonus depreciation may be taken.
- Reduce Taxable Income
Planning Tip: Make sure you understand your state’s laws. Many states have decoupled from some of the features of the CARES Act which may cause REITs with zero federal taxable income to still have taxable income due to state laws.
- Delay Dividends
- Partial Stock Dividends
- Consent Dividends
- Dividend Limitation in Rescue Funds Under the CARES Act.
- Loan Workouts. Whether there is debt forgiveness or a property foreclosure, REITs face possible tax consequences. Strategy for distributing the income or gain to avoid corporate level income tax, when there is no cash generated from the transaction, is key. Cancellation of debt income is may not be required to be distributed under the 90% distribution requirement to maintain REIT qualification, and is disregarded for the REIT gross income tests. However, undistributed cancellation of debt income is subject to corporate income tax.
Other Tax Planning Strategies
- Private REITS can consider making adjustments or amendments to their 2019 tax returns to lower 2019 taxable income for the REITs shareholders and reduce the income that they generally have to pay.
- Payroll Tax Deferral and Employee Retention Credit.
- Deferral of gains. The IRS has postponed certain deadlines in IRC Section 1031 transactions and for investments in qualified opportunity funds.