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REIT Tax Rule Could Help in a Downturn

Cryptic rule may give REIT shareholders a dividend without nixing the tax deduction for the trust.
Robert Willens, | US
May 6, 2008

In a sputtering economy, owners of real estate investment trusts (REITs) may want to consider a novel approach to dividend payouts — use stock to conserve cash. The downside, however, is that the REIT could put its dividend tax deduction in jeopardy if it uses stock, rather than cash, to keep shareholders happy. But buried in the tax code is an obscure rule that may allow REITs to have their cake and eat it too. Consider the following tax facts.

Contrary to popular belief, REITs are not statutorily exempt from tax. To be sure, their favorable tax status is triggered only when certain affirmative actions are taken. In the absence of such actions, tax on a REIT's taxable income will be imposed. Thus, the IRS provides — in Section 857(b)(1) — that "...there is hereby imposed for each taxable year on the REIT taxable income of every REIT a tax computed as provided in Sec. 11..." Section 11 is the corporate tax section of the IRS code.

Fortunately, REIT taxable income (upon which the corporate tax code is otherwise imposed) is calculated in an eclectic way, and taxable income is adjusted as follows: the deduction for dividends paid, as defined in Section 561, shall be allowed. Therefore, REITs can reduce their REIT taxable income by certain dividends they remit to their shareholders.

For this purpose, however, the term, dividend, shall include only dividends described in Section 316(a). A dividend, within the meaning of Section 316, means any distribution of property made by a corporation to its shareholders out of its earnings and profits.

Again, for this purpose, property — as defined in Section 317(a) — means money, securities, and other property except stock in the corporation making the distribution (or rights to acquire such stock.) So, it would appear that a cash-strapped REIT cannot secure a dividends paid deduction — which will have the effect of reducing its REIT taxable income — with respect to distributions of its stock (or rights to acquire such stock).

Stock as Property
Notwithstanding Section 317(a), a distribution of stock shall be treated as a distribution of property to which Section 301 applies under certain circumstances. The main criteria being that within the meaning of Section 305(b)(1), the distribution is payable either in its stock or in property at the election of any of the shareholders. In fact, Regulation Section 1.305-2 elucidates this cryptic rule.

It provides that if any shareholder "has the right to an election" with respect to whether a distribution shall be made either in (1) money or any other property, or (2) the distributing corporation's stock (or rights to acquire such stock), then with respect to all shareholders the distribution of stock is treated as a distribution of property to which Section 301 applies. Further, the stock is treated as property regardless of whether the distribution is actually made in whole or in part in stock — and all or only a portion of the shareholders have the election.

The affirmative use of the rule was recently illustrated in guidance issued by the Internal Revenue Service (Letter 200817031, January 28, 2007.) In the example laid out the IRS letter, the taxpayer — a REIT — intends to "make a dividend" of approximately "$A" on or before Date 2. The taxpayer expects to "make the dividend" in the form of cash, common stock, or a combination of cash and common stock, at the election of each of its shareholders. The dividend declaration provided that "the total amount of cash paid will be limited to '$B' " but in no event will the total amount of cash paid be less than 20 percent of the total value of the dividend. Within these guidelines each of the REIT's shareholders may elect to receive cash, stock, or a combination of both.

The ruling provides the REIT with exactly what it was looking for. To be sure, the guidance concludes that (1) any and all of the cash and stock distributed shall be treated as a distribution of property to which Section 301 applies, and (2) the amount of the distribution of the stock will be considered to equal the amount of money which could have been received instead.

As a result, the ruling concludes that the distribution of the REIT's stock constitutes a distribution of property (to which Section 301 applies.) Accordingly, assuming sufficient earnings and profits, the distribution of stock will be a dividend eligible for the dividends paid deduction.

The portion of the ruling governing the amount of the distribution (remitted in stock) is derived from Regulation Section 1.305-1(b)(2). That rule states that"...where a corporation (like a REIT) which regularly distributes its earnings and profits declares a dividend pursuant to which the shareholders may elect to receive money or stock of equivalent value (the case here) the amount of the distribution of stock will be considered to equal the amount of money which could have been received instead..."*

Historically, REITs had only resorted to this "desperate" tactic — of defraying their dividend responsibilities with stock — when they converted from 'C' corporation status to REIT status. During such a transition, a REIT would have to comply with the requirement that it cannot, at the close of any taxable year, have any earnings and profits which were accumulated in non-REIT years (see Section 857(a)(2)(B).) However, in these times, we should probably be prepared to see the more widespread use of this strategy in instances where the REIT is simply attempting to conserve cash while insuring that its secures a dividends paid deduction in an amount sufficient to completely "zero out" its REIT taxable income.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

*Ordinarily, in cases where a distribution of stock is treated as a distribution of property to which Sec. 301 applies, the amount of the distribution is measured by the fair market value of the stock on the date of distribution.

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