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REIT-Specific Tax Considerations in the COVID-19 Era

REIT-Specific Tax Considerations in the COVID-19 Era Background Decorative Image

As a result of COVID-19, the markets have been in turmoil and businesses — and thus, tenants and borrowers — have been struggling. Real estate investment trusts (“REITs”) are facing, and will continue to face, additional challenges complying with the REIT tax requirements. REITs should be proactive in preparing for any limitations on their operational flexibility arising from the need to comply with the REIT rules, as well as looking for ways that they can structure their operations within the bounds of the REIT rules to weather this difficult time.

  • Liquidity Levers – All REITs are required to distribute 90% of their “REIT taxable income” on an annual basis (the “90% Distribution Requirement”). To preserve cash on hand, or to the extent that a REIT does not have enough to make sufficient distributions, REITs should consider taking the following actions:
    • Make Elective Cash/Stock Dividends. Under Revenue Procedure 2017-45, a “publicly offered” REIT (i.e., a REIT that is required to file annual and periodic reports with the SEC under the Exchange Act) may make distributions in a mix of up to 80% stock/20% cash and receive a dividends paid deduction. Given the current economic climate, NAREIT recently requested that the Internal Revenue Service (“IRS”) increase the allowable mix up to 90% stock/10% cash for 2020 and 2021, which could provide additional relief to cash-strapped REITs.
    • Minimize Distributions. While most REITs annually distribute 100% of their taxable income, a REIT may consider distributing only 90% of its REIT taxable income. Although the retained income would be subject to tax at the U.S. corporate income tax rate of 21%, retention of these funds could create additional liquidity for the REIT.
    • Retain Capital Gains. A REIT is not required to distribute its capital gain net income, but may retain such income and pay U.S. corporate income tax at the 21% rate on it. However, to the extent a REIT distributes less than the sum of 85% of its REIT ordinary income, 95% of its capital gain net income and any undistributed taxable income from prior years, the REIT will be required to pay a 4% nondeductible excise tax on the excess of such required amount over the amount actually distributed. REITs looking to increase liquidity may consider retaining capital gains and opting to pay tax on these capital gains.
    • Defer Tax Payments. To the extent a REIT has one or more taxable REIT subsidiaries (“TRSs”), these TRSs will generally be able to defer payment of their U.S. federal income tax liability for the 2019 taxable year under an economic stimulus plan announced by the Trump administration on March 17, 2020, which allows corporations to defer up to $10 million in tax payments until July 14, 2020. REITs with TRSs should consider deferring payment of taxes under this plan.
  • REIT Testing Issues
    • Cancellation of Indebtedness Income. Cancellation of debt (“COD”) income generated by debt forgiveness or modifications is excluded from both the numerator and denominator for purposes of both the 75% and 95% REIT gross income tests. Thus, REITs incurring COD income as a result of debt restructurings need not worry about its impact on the REIT gross income tests. In addition, COD income is considered an item of “excess noncash income” for purposes of the 90% Distribution Test. To the extent COD income, plus any other excess noncash income, exceeds 5% of the REIT’s taxable income, such amount will reduce the 90% Distribution Requirement.
    • Modifications of Loans Where the REIT is the Lender. Generally, when a REIT modifies a loan in a manner that is considered “significant” for tax purposes, the REIT is required to retest whether the loan is fully secured by real property on such date for purposes of the REIT asset and gross income tests. However, existing IRS guidance provides that such retesting is not required if the REIT (or the loan servicer) reasonably believes there is a significant risk of default on the loan and that the modification substantially reduces that risk.
    • Foreclosures. If a REIT forecloses on a loan, there are two considerations: (1) whether income and gain from the property will qualify for purposes of the REIT gross income tests and (2) whether the subsequent sale of the property will be subject to the 100% prohibited transactions tax. To mitigate these concerns, a REIT may elect to treat property received in foreclosure (including a deed in lieu) as “foreclosure property.” A REIT must distribute 90% of its net income from foreclosure property.
  • Other Tax Considerations
    • Loan Modifications – REIT as Borrower. As discussed above, a REIT may exclude COD income from its gross income testing, and part of such COD income may not be subject to the 90% Distribution Requirement. Under the current circumstances, a likely source of COD income would be a modification of property-specific indebtedness or credit facilities.
      • Like a regular C corporation, a REIT may claim insolvency or bankruptcy to exclude COD income.
      • Loan modifications may trigger tax consequences for borrowers. As noted above, “significant” loan modifications are considered taxable exchanges of the old debt for the new modified debt. The determination of whether a modification is significant is highly subjective and based on all the facts and circumstances. A borrower may be required to recognize COD income in connection with the exchange to the extent of the difference between the adjusted issue price of the old debt and the issue price of the new debt. If a borrower conveys the property to the lender, the tax treatment will depend on whether the loan is recourse or non-recourse. If the property is conveyed to a lender in satisfaction of a debt and the obligation is a recourse loan, the borrower will generally have COD income. Conversely, if the obligation is non-recourse, the borrower will be required to recognize gain to the extent of the excess of the debt over the basis of the property.
    • Loan Modifications – REIT as Lender. From a lender perspective, the exchange could result in immediate gain or loss recognition on the loan. In addition, if the loan is issued with original issue discount (“OID”), the lender will be required to include the OID in its taxable income over the life of the loan.
    • Repurchase of Debt at a Discount. A REIT that repurchases its debt at a discount will generally recognize COD income. The amount of COD income will generally be the difference between the principal amount of the debt repurchased (or its accreted value, if applicable) and the repurchase price. The same result occurs when a person related to the REIT repurchases debt at a discount. REITs considering repurchasing debt or having a related party purchase its debt at a discount should consider the potential COD income that could result from such repurchase.

For a more complete business perspective on COVID-19 please see: Key Considerations During COVID-19 Pandemic and Market Disruption

Please visit our Coronavirus: Preparation & Response series for additional resources we hope will be helpful.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.