2.24.20 | Industry Insights – REIT Special Edition
One of the more attractive aspects to investing in real estate can be the tax benefits provided by depreciation. Often, depreciation will take a cash flowing real estate venture and supplement that economic positive through tax losses as well. Economic income and tax losses: The best of both worlds! While the purchase price of a building (land is non-depreciable) is typically depreciated over 27.5 to 40 years (depending on residential vs. commercial, and some special Tax Cuts & Jobs Act provisions), other asset types such as furniture & fixtures, machinery, and land improvements can be depreciated at a faster pace (5 to 15 years). If this wasn’t attractive enough, the Internal Revenue Code permits, and actually assumes, the immediate recovery of 100% of the basis of these faster paced assets in the first year. Accordingly, absent an election to the contrary, the entire purchase price of your machinery, furniture, and fixtures, or capital expenditure for land improvements, will result in a tax expense in the first year they are placed into service. Known as bonus depreciation, the results can be tax losses galore!
“…if you have partnered with a REIT for your real estate venture, the REIT may request, demand, or have contractually obligated that you forego bonus depreciation…”
This, of course, is where I notify you that if you have partnered with a REIT for your real estate venture, the REIT may request, demand, or have contractually obligated that you forego bonus depreciation. Wave goodbye to those exceptionally oversized immediate losses. Why would they want to pass up the acceleration of losses, you ask? The answer has to do with the distribution requirement of REITs and how it interacts with the REITs earnings & profits (E&P).
As you may recall from the introductory blog-ish, only the retained earnings of a REIT are taxed, provided the REIT meets five specific requirements; one of which relates to distributions. To retain REIT status, a REIT must distribute dividends equal to at least the sum of:
- 90% of REIT taxable income
- 90% of after-tax net income from foreclosure property
- Less: excess of the sum of certain items of noncash income over 5% of REIT taxable income
Furthermore, there is a 4% additional excise tax if the REIT fails to distribute at least 85% of its ordinary income and 95% of the capital gains.
Despite what at first sounds like a draconian set of overly precise rules, most REITs don’t have too much trouble meeting the economic aspect of the distribution requirements (and if they do there are a few exceptions or planning techniques at their disposal to avoid penalties or status disqualification) and receiving a full Dividends Paid Deduction (DPD). This is because the Internal Revenue Code rules are almost set up to help the REIT succeed in this regard. You also might be wondering: wouldn’t the amount a REIT needed to distribute be reduced significantly in a year with bonus depreciation, making it easier to satisfy? While the answer is technically yes, compliance with the basic distribution requirement only tells a small piece of the story. The interaction with DPD, E&P, and shareholder income inclusion is, perhaps, an even more important factor.
Under IRC Section 562, a DPD is allowed only to the extent of REIT E&P. While E&P is not defined in the Code, it is akin to taxable income, with some differences. Notably, E&P is adjusted for straight-line depreciation instead of accelerated depreciation (see Reg. Section 1.168(k)-1(f)(7)). Because of the differences between REIT taxable income and REIT E&P, a REIT may lack sufficient E&P to have a DPD that reduces its taxable income by the required 90% . Some REIT specific rules pertaining to E&P have been enacted to ease a REITs’ compliance with the distribution requirements, but some of these REIT-specific adjustments can considerably complicate the computation of E&P. For example, IRC Section 562(e) increases a REIT’s current E&P, but only for purposes of REIT DPD, attempting to ensure that a REIT will have sufficient current E&P to make the dividend distributions necessary to meet REIT requirements and prevent REIT level taxation, while also not subjecting the shareholders to additional taxable dividend income.
“If bonus depreciation is taken, a mismatch is created between taxable income and E&P that can result in more of a REIT’s distributions being taxable dividends to its shareholders than would otherwise occur.”
Shareholder consequences also flow from the DPD and E&P interaction. When REITs distribute cash to their shareholders, there are a variety of possibilities for the recipient. Depending on the E&P and categories of income generated during the year, the distribution could be classified as an ordinary dividend (for operating income), capital gain (from property sales), or even qualified dividends (for dividends received from other corporations or taxable REIT subsidiaries that were subject to tax at some point). Additionally, the distribution could constitute a return of capital to the shareholder (reducing their basis in their REIT stock) or capital gain if the distribution isn’t a dividend and exceeds the stock basis.
However, IRC Section 857(d)(2) provides that a REIT will be deemed to have sufficient E&P to treat any distribution as a dividend to the extent necessary to avoid the Section 4981 excise tax (a 4% excise tax on a REIT that fails to distribute at least 85% of its ordinary income within the same tax year).
It also creates a mismatch on the state level—in states that don’t allow bonus depreciation, the addback will cause the REIT to pay tax in that state, but in future years, the subtraction won’t benefit the REIT since they must make distributions based on federal income.
I’ll save you from further technicalities at this point and cut to the net result of these interacting forces of REIT taxable income, E&P, DPD, and shareholder income: If bonus depreciation is taken, a mismatch is created between taxable income and E&P that can result in more of a REIT’s distributions being taxable dividends to its shareholders than would otherwise occur. This simple statement will likely be the driving force why your REIT joint venture partner requests or demands that you opt out of bonus depreciation and forego those juicy (at least for non-REIT), upfront deductions. Now, when this request comes in, there won’t be any surprises, and you can also potentially adjust how you underwrite a project knowing this will likely be the outcome.
Questions? Please contact Evan Fox at 212.331.7477 | firstname.lastname@example.org or your Berdon LLP tax advisor.