Industry Insights

Many industries have faced tough economic times in recent years. Washington responded with various incentive packages and favorable rulings to help revitalize and stimulate troubled sectors of the economy. Real Estate Investment Trusts (REITs) are among the entities on the receiving end of these actions. Hopefully, there are similar incentives in the pipeline.

The Dividend

REITs are required to distribute 85% of the current year ordinary income and 95% of the capital gain income to shareholders. A dividends-paid deduction is allowed against taxable income. In 2008, the Internal Revenue Service (IRS) provided guidance that allows REITs to distribute stock dividends to shareholders. This is a big departure from prior “cash only” regulations. Although many believe there is a position to support the distribution of cash equivalent dividends by REITs, the IRS did not support this risky proposition. Revenue Procedure 2008-68 changed this, at least temporarily.

Allowing REITs to effectively distribute their own stock instead of cash was certainly aimed at providing liquidity as well as helping REITs conform to timely regulations. REITs that choose to declare stock dividends can retain much-needed cash yet continue to conform to distribution requirements.

The REIT, which must be publicly traded under these rules, can declare the cash/stock dividend for tax years ending on or before December 31, 2009. The declaration must allow shareholders to elect to receive cash instead. Although a minimum portion of the dividend must be paid in cash, the REIT may limit the total amount of cash dividend. This limit cannot be less than 10%, and the dividend may not be preferential within a particular class of stock. The computation of the number of shares distributed must be derived with a formula based on current market prices. Dividend reinvestment plans only would apply to any elected cash distributions.

These rules were expanded in 2009 to include regulated investment companies (RICs). Both industry groups are pushing to have these rules extended beyond the December 31, 2009, sunset.

Prohibited Transactions

REITs are subject to regulations that provide for penalties of 100% of the income from certain prohibited transactions. These transactions are not, however, subject to the penalty if they occur inside the REIT’s taxable subsidiary (TRS). The regulations prohibit certain types of income from being captured under REITs and the beneficial taxation of REITs. One prohibited transaction is the sale of property not previously held for rental for a sufficient period of time. Under prior safe harbor regulations, a REIT could not sell real property owned unless it had been held for rental for four years. The regulations also prohibited REITs from holding and selling “dealer property,” which is property held for sale and not rental.

The Housing and Economic Recovery Act of 2008 (HERA) eased safe harbor rules related to these prohibited transactions. For sales after July 31, 2008, the required holding period was decreased from four years to two years. The rule on dealer property did not change, as these transactions are still subject to penalties. HERA also eased other safe harbor rules by allowing some other limitations to be calculated on either fair market value or tax basis, whichever is favorable to the REIT. Corresponding to this change, the amount of a REIT’s investment in its related TRS was increased from 20% to 25%.

This easing of safe harbor requirements on prohibited transactions also was aimed at assisting REITs by allowing them to either dispose of property sooner than before or invest more in “prohibited transaction” property with the TRS.

What Is Infrastructure?

Current regulations prohibit REITs from investing in and receiving income from assets not considered to be real estate. Historically, regulations have precluded REITs from investing in and deriving income from the operation of infrastructure assets, such as toll roads, bridges, ports and the like. One of the main issues is that regulations do not consider governmental permits to be “real estate assets” for REIT purposes.

Some industry groups want to open up the infrastructure sector to REIT investments. Considering the aging U.S. infrastructure and current administration’s call to invest in new assets, there is some hope this may happen. A legislative fix may very well be needed for this opportunity to materialize.

Conclusion

The publicly traded REIT industry is, by many measures, a very small sector of the economy. It is comforting to see attempts to assist this sector. Many of the broader recovery initiatives also may favorably impact this industry, but initiatives focused on the REIT industry are encouraging.

For more information on this issue or related matters, please contact your BKD advisor.