REITs Accruing Rent Without Receiving Corresponding Cash Payments Need to Start Considering Their Options Now
Under Section 857(a) of the Internal Revenue Code of 1986, as amended (the Code), a REIT generally must distribute 90 percent of its taxable income to its stockholders annually. REITs generally qualify for a dividends paid deduction. Accordingly, a REIT will almost always try to make distributions equal to 100 percent of its taxable income and claim the entire amount as a dividends paid deduction so as to avoid the REIT having to pay federal income tax at the REIT level.
Section 448 of the Code requires accrual method accounting for a corporation with average annual gross receipts exceeding a threshold amount ($26 million for 2019 and 2020) for the three prior taxable years. As a result, most REITs must accrue rental income as it is earned, even if REITs do not receive payments of the rent. With many business tenants of REITs shut down or operating at low capacity, REIT landlords are now at risk of finding themselves in the unenviable position of accruing substantial amounts of taxable rental income but being short on cash.
Despite these difficulties, each REIT must still comply with distribution requirements to maintain its REIT status—namely, in general, to distribute 90 percent of its taxable income, before taking into account the dividends paid deduction, to its stockholders annually—and, preferably, to “zero out” its taxable income by making distributions equal to 100 percent of its taxable income.
While many REITs are facing a cash crunch, REITs leasing to tenants operating businesses in industries that are suffering the most, such as the hotel and retail industries, generally are facing the greatest liquidity challenges.
REITs should begin now to consider possible approaches to alleviate the problems of accruing rental income but not receiving the corresponding cash from their tenants. REITs may want to employ multiple approaches, not just one. We discuss some possible approaches below.
Borrowing or Selling Assets
Some REITs, having saved as much as they can by cost-cutting, may find that borrowing or selling certain assets is the best approach to raise cash. Of course, the current economic climate may not be the best one for a sale.
REITs raising cash using either approach will need to ensure they avoid violating the quarterly REIT statutory asset tests. The 75 percent asset test generally requires that at least 75 percent of the value of a REIT’s assets must consist of real estate assets, cash, cash items, and US government-issued or guaranteed securities as of the close of each quarter of the taxable year. REITs that invest excess cash from borrowings until the cash is needed for distributions in other types of financial securities and instruments need to take care that such investments do not cause them to fail the 75 percent asset test, such as by purchasing mortgage-backed securities that qualify as good real estate assets for REIT qualification purposes. (REITs generally can cure any violations within a 30-day period after the close of a quarter.)
A REIT that is considering selling assets must be mindful of the consequences of being treated as holding such assets primarily for sale to customers in the ordinary course of a business, which itself could jeopardize REIT qualification. If a sale of such property does not qualify for a safe harbor, the REIT might be treated as engaging in a “prohibited transaction,” subjecting the REIT to a tax equal to 100 percent of the income from the sale.
REITs that borrow in 2020 eventually will have to repay the loan. Rent that was previously accrued but unpaid in 2020 might be paid in 2021 or in a subsequent year, allowing for some, or all, of the loan to be repaid. Moreover, if the previously accrued but unpaid rent becomes uncollectible in 2021 or in a later year, it could be written off as a bad debt, thus reducing the REIT’s taxable income (and corresponding distribution obligations) in the year of the write-off, which would free up cash for loan repayment.
Working with the Code
The REIT provisions in the Code provide for some relief around the edges, which can be combined with other approaches:
- Under Section 858 of the Code, a REIT satisfying certain procedural requirements can elect to treat certain dividends as having been distributed in the current year for purposes of the REIT distribution requirement, even though they are actually made in the following year (even at the end of the following year). The REIT shareholders would be taxed at the time they actually receive the distribution. To use this approach, among other requirements, the REIT must declare the dividend before the time expires for filing its federal income tax return (including any extension, which generally can extend the time to September 15 of the following year). A four percent excise tax is generally imposed on the difference between the amount the REIT is required to distribute for the current year (85 percent of REIT ordinary income, plus 95 percent of capital gain net income) and the amount it actually distributes for the current year. The nondeductible four percent excise tax is equivalent to an interest charge on part of the income deferred by using Section 858. This approach could be relied upon to the extent a REIT fails to meet the distribution requirement at the end of 2020. To the extent tenants defer their accrued but unpaid rent only into 2021, this approach may provide a viable path forward.
- Certain items of “excess noncash income” do not have to be distributed by REITs. Noncash income qualifying for this exception can include cancellation of indebtedness income arising from a workout with a REIT’s lender and certain income items arising from a REIT landlord and a tenant agreeing to defer rents where Section 467 of the Code applies.
- Section 857(b)(9) of the Code provides for the ability of a REIT to declare a dividend in the last quarter of a year (such as 2020) and to make the dividend in January of the following year (such as 2021), treating the dividend as being made on December 31 of the prior year (here, 2020).
- Another approach to consider is to make a distribution between 90 percent and 100 percent of taxable income (excluding net capital gains and certain non-cash income), so that the REIT satisfies the distribution requirement of the Code but at the same time is spared the need to pay additional cash. This would cause the REIT to pay corporate income tax at both the federal and state level on the difference between the REIT’s taxable income and the amount distributed. The maximum federal corporate income tax rate is 21 percent. But it would also spare taxable shareholders from paying income tax on the income that is not distributed (except that some shareholders are US tax-exempt organizations that would not be subject to tax on distributions, and this approach would cause them to bear indirectly the burden of federal income tax paid at the REIT level). Nonetheless, this approach may be useful as one of several strategies for a REIT to deal with the cash crunch until tenants are again in a position to pay most or all of their cash rent. (A REIT may also choose to retain all or part of its long-term capital gains, but doing that would also subject the undistributed amounts to regular corporate income tax rates).
Alternatives to Cash-Only Distributions
There are a few alternatives to cash distributions that can have varying levels of utility, depending upon the REIT’s circumstances.
1. Consent Distribution
A consent distribution is a fictional distribution that is treated as though a specified dividend amount was paid to the stockholder as of the end of the year but is then deemed to be immediately contributed back to the REIT by the stockholder. The deemed distribution is taxable to the stockholder. Accordingly, this may not be the most practical approach, unless the financial circumstances of the REIT are truly dire or the bulk of its direct or indirect owners are US tax-exempt entities. In addition, because generally all stockholders must agree to the consent dividend, it is practical only for private REITs. This approach could also be practical if there are a small number of material shareholders who all understand the REIT’s cash crunch.
2. Property and Stock Distributions
REIT distributions are typically paid in cash, but they may also be paid in property, such as real property or stock. Distributing stock or other property in lieu of cash can address the cash shortfall experienced by the REIT.
Distributions of real property and property other than stock is practical, if at all, generally only with private REITs. In certain instances, a REIT may be willing to divest itself of certain properties where the REIT has a small stockholder base. The distribution generally would need to be made to stockholders on a pro rata basis. A non-pro rata redemption that is not “essentially equivalent to a dividend” would not satisfy a REIT’s distribution requirements. In any event, property distributions can create additional tax issues. A distribution of appreciated real property or property other than stock would trigger gain inside the REIT as if the real property was sold at its fair market value, and the distribution of depreciated property would result in a loss that could not be claimed by the REIT.
Distributions of stock are likely to be the more popular approach for public REITs. While stockholders generally prefer cash distributions, a stock distribution would give them the opportunity to benefit from a stock price that may currently be low, but is likely to rebound over time.
Stock distributions must qualify as a taxable dividend under Section 305(b) of the Code. A pro rata distribution that is solely of stock is generally not treated as a distribution of property that qualifies as a taxable dividend for income tax purposes. Accordingly, such a distribution would not help a REIT satisfy its annual distribution requirement. Section 305(b) treats a stock distribution as a qualifying distribution of property if:
- The distribution is made using stock, cash, or other property at the election of the stockholder (stock and cash, the cash option approach);
- The distribution is disproportionate among the stockholders; or
- The distribution has the effect of some stockholders receiving common stock and other stockholders receiving preferred stock.
Providing for the cash option approach is the most common choice for REITs when liquidity is a serious issue. In response to the cash crunch, REITs may want to have as little cash as possible paid to stockholders using the cash option approach, but they also want to use enough cash for the stock distribution to qualify under Section 305(b).
IRS Revenue Procedure 2017-45 sets out a safe harbor for the cash option approach. Unfortunately, it applies only to publicly-traded REITs. Under this permanent safe harbor, a distribution of stock and cash will be treated as a distribution of property for federal income tax purposes if: (1) at least 20 percent of the total distribution is paid in cash, and (2) stockholders have the option to elect to receive either stock or cash (or both). Further, the stockholder election must have a mechanism for pro rata allocation of shares if stockholders oversubscribe for cash (which is the most likely scenario). The REIT must also use a formula for calculating shares utilizing the market price of the shares and stock prices no more than two weeks from the distribution date.
The IRS, recognizing the current economic crisis caused by COVID-19, recently temporarily modified Revenue Procedure 2017-45 by issuing Revenue Procedure 2020-19, which is also applicable to publicly-traded REITs (but not private REITs). The minimum aggregate amount of cash that must be distributed to all stockholders in order to satisfy the safe harbor is reduced from at least 20 percent to at least 10 percent for distributions declared on or after April 1, 2020, and on or before December 31, 2020. (Said another way, if all stockholders elected cash, each would receive at least 10 percent of such shareholder’s distributions in cash).
While the two revenue procedures provide certainty only for public REITs desiring to adopt the cash option approach, private REITS are not barred from using the cash option approach. They just will not have the ability to rely on a safe harbor. In the early 2000s, the IRS issued several private letter rulings approving cash option elections where at least 20 percent of the total distribution would be received in cash. While a private letter ruling can only be relied upon by the taxpayer to which it is addressed, it may provide insights into how the IRS views an issue. On the other hand, the fact that the IRS did not extend the safe harbor to private REITs suggests that the IRS is concerned about private REITs using cash option elections. One of the difficulties is valuing the stock of the private REIT so that the REIT can be assured that a sufficient amount of cash consideration is being made available to shareholders.
A REIT may benefit by agreeing to provide rent deferral or even partial forgiveness of rent payments.
1. Stopping the Accrual of Rent
A logical question for REITs to ask is whether, where the tenants are unlikely ever to pay the overdue rent, the accrual of the rental income from their tenants can stop. Accrual method taxpayers generally must recognize income when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. Arguably, if there is a reasonable expectation of nonpayment by a tenant, it may be possible for the landlord to stop accruing rent. The courts have sanctioned this approach in the context of interest accrual, and landlords may consider making a similar argument in the context of lease accruals. Arguably, similar standards should apply to accruals of rental income. In any event, the temporary inability of a tenant to pay rent would not qualify for stopping the accrual of rent.
2. Rent Forgiveness
If a REIT believes that a particular tenant is unlikely ever to be in a position to pay overdue rent, the REIT could forgive all or a portion of the accrued but unpaid rent by the end of 2020. By doing so, the REIT should be entitled to write off the accrued rent, thus reducing its taxable income (and at the same time reducing the amount of distributions needed to be made to stockholders).
Any rent forgiveness could result in taxable income to the tenant, although an exception generally would be available to the extent the tenant is insolvent or bankrupt. The tenant may also have operating losses in 2020 that could offset forgiveness of debt income.
3. Lease Modifications
A popular approach may be to amend leases to provide tenants with temporary deferrals of rent, thereby giving them breathing room to recover and avoid default.
The parties need to consider the potential impact of Section 467 of the Code if the lease modification results in a material deferral of rent. Section 467 can apply to a lease of real estate where the “allocated” rent in the early years of the modified lease exceed the rent payable. Rent is allocated to a period if the rental agreement clearly specifies a fixed amount of rent for which the tenant becomes liable on account of the use of the property during that period (regardless of whether rent is paid in that period).
If there is deferred rent that triggers the application of Section 467, landlords may be surprised to learn that they must generally accrue the allocated rent for the tax year (less a small present value amount), rather than accrue the smaller amount of rent payable for such year. As a result, a rent deferral subject to Section 467 might not address the accrual of rent issues that currently vex many REITs. In addition, if Section 467 applies to a rent deferral, a loan will be deemed to be made from the landlord to the tenant. The landlord would have imputed interest income, while the tenant would have imputed interest expense (which may be limited by Code Section 163(j), whose impact was recently softened for 2019 and 2020 by the recently-enacted CARES ACT).
A lease modification can be structured to avoid Section 467. If the rent allocation schedule and the rent payment schedule are identical, which is common, then Section 467 will not apply. In any event, if the deferral is generally no longer than one year, Section 467 would not apply. Moreover, for real estate leases, rents may vary as much as 85 percent and 115 percent of the average annualized rents without triggering Section 467. In determining whether the 85 percent/115 percent uneven rent test has been met, any rent allocated to a rent holiday period that does not exceed the lesser of 24 months or 10 percent of the lease term would be disregarded. There is also a safe harbor for a change to provisions in the lease requiring that the tenant reimburse the landlord for third-party costs, such as property taxes, insurance, or maintenance, and for late payment charges.
REITs generally no longer have to worry that lease modifications risk a violation of the 10 percent asset tests. These tests are violated if the REIT holds securities having more than 10 percent of the voting power or value of the outstanding securities of any one issuer. Section 467 rental agreements (other than with a related party, such as a taxable REIT subsidiary (TRS)) and any tenant real estate rent obligations are not treated as securities for purposes of this asset test. Additionally, REITs need to keep in mind that for the rent to be qualifying REIT income, rents cannot be based on the tenant’s net income, profits, or current cash flow (except for percentage rents based on gross income or receipts). Hotel REITs also need to consider whether entering into a forbearance agreement with a related-party TRS would make the lease look more like a lease based on the TRS’s net income or profits.
A REIT landlord may be able to combine a rent deferral with a “quid pro quo” that benefits the landlord, such as a lease extension. Any such modification should be evaluated to determine whether it could cause the lease to become subject to the special accrual rules under Section 467.
Whether from government-mandated tenant relief or from tenants’ general inability to pay rent, the combination of the economic disruption caused by the COVID-19 pandemic and stringent federal tax REIT rules have placed landlord REITs in a difficult position where multiple approaches might be required to maintain liquidity. The earlier in the tax year a REIT can employ these strategies, the more flexibility the REIT will have to deal with the distribution requirement. To discuss how the approaches described above may benefit your REIT, please contact the tax professionals of Arent Fox LLP.