Understanding the tax effects of REIT investments.

• Author: Nickell, Christopher G.
• Position: Real estate investment trusts

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...