Understanding the tax effects of REIT investments.

There has been a substantial interest--especially in light of recent tax law changes--in dividend-paying stocks, which has caused an increased interest in the usually high-yielding shares of real estate investment trusts (REITs). However, many investors in REIT shares do not fully understand that a substantial portion of the dividends paid are nontaxable or considered capital gain (CG). These nuances can cause a substantial difference in current tax liability and/or tax deferral.

E&P

The taxability of dividends stems from calculating earnings and profits (E&P), which measures a corporation's economic income. Under Sees. 301(c)(1) and 316(a)(2), E&P is neither GAAP earnings nor taxable income; it is simply a measure of a corporation's ability to pay dividends from its economic earnings. Specifically, two of the many differences between taxable income and E&P are the inclusion of tax-exempt income and differing depreciation lives. Generally, the calculation works tot more traditional corporations (e.g., manufacturers or retailers), because they are using truly depreciating assets in their businesses, while not receiving a current deduction (for taxable income or E&P) for their inventory. On the other hand, real estate corporations are allowed a depreciation deduction (for both taxable income and E&P purposes) for their assets (substantially real estate), which generally appreciate. In other words, real estate corporations receive a current deduction (depreciation) for their inventory--real estate--that may have a tremendously long operating cycle.

Clearly, neither E&P nor taxable income is a good way to measure a real estate corporation's ability to pay dividends; cashflow would be a more appropriate measure. Despite this, the tax law uses E&P to measure a real estate corporation's earnings.

How It Works

Generally, any dividend deemed paid out of E&P is an ordinary dividend taxed at the same rate as net long term CG. Dividends paid in excess of a corporation's current or accumulated E&P are a return of the investor's capital (ROC); any remaining dividend is CG. Additionally, as a departure from the standard E&P rules, CGs within a REIT retain their character on subsequent distribution to the shareholder.

Normally, REITs seek to maximize dividend payments to investors and often distribute dividends well in excess of Sec. 857(a)(1)(A)(i)'s 90%-of-taxable-income requirements. Often, this is easily achievable, as cashflow can well exceed either taxable income or calculated E&R The biggest cause for this discrepancy is the difference between depreciation in excess of principal payments on loans. Additionally, because REITs generally do not reduce dividend payments for fear of damaging shareholder value, they often do not do this when the timing differences in depreciation and loan principal payments turn around. Given these dividend yields in excess of taxable income and E&R REITs often issue dividends that have a mixed tax character.

Example: B, an investor in REIT R, invested $10,000 for stock with a $10,000 current fair market value and a 10% dividend yield (i.e., $1,000 in dividends). Alter an E&P calculation, R reports to B that 40% of the dividends are ordinary, 25% are ROC and 35% are CGs. An estimated tax calculation might be:

$1,000 x 40% x 15% (dividend tax rate) = $60 $1,000 x 25% x 15% (adjustment to basis) = $0 $1,000 x 35% x 15% (CG tax rata) = $53 Total tax an dividends = $113

In the example, B (an individual) would pay an effective tax rate of 11.3%. Of course, this would be lower if B had capital losses to offset against the $350 of CG dividends; the effective rate could be as low as 6%. The $250 of ROC dividend is an adjustment that reduces B's basis to $9,750 ($10,000 - $250), which creates a deferral triggered on a sale (or even a permanent deferral, assuming a basis step-up on death).

Functionally, this ROC distribution resembles a nontaxable cashflow representative of the depreciation deduction. In light of the calculation, the REIT shares could be perceived as a surrogate for actual real estate investments, as Congress intended. Additionally, the tax rate on the ordinary and CG portions of the dividend would be reduced below 15% if B were in a lower tax bracket.

Conclusion

The analysis indicates that the best investor in REIT shares is an individual in a high tax bracket who desires a high after-tax cashflow yield. Despite this, some of the largest investors in REIT shares are institutions, especially qualified pension and retirement plans. This does not seem like the best investor class, as such investors cannot take advantage of the favored tax position available to REIT shares. Of course, qualified plans get an extended deferral until the funds are withdrawn by a beneficiary, but all funds are taxed at the highest marginal ordinary income tax rates at that point. Arguably, REIT shares would be a better investment in an individual's taxable account, while high-yield investment-grade corporate bonds would generate better cashflow for a qualified plan, as corporate bonds are subject to ordinary income rates anyway.

CHRISTOPHER G. NICKELL

MSRE 

MTX, ATLANTA, GA