During these uncertain economic times, real estate investment trusts (REITs), like most businesses, are focused on maintaining operations and preserving cash. Recent federal legislation including the Families First Coronavirus Response (FFCR) Act, the Coronavirus Aid, Relief, the Economic Security (CARES) Act and various IRS rulings have provided relief opportunities for REITs and the real estate sector in general. Below are some of the primary considerations REITs should keep in mind as they navigate these uncertain times.
During an economic slowdown, “cash is king” as the saying goes. REITs should consider all options to preserve cash. Below are various cash preservation strategies REITs should keep in mind.
Cost segregation studies: By accelerating non-cash deductions, such as depreciation, REITs can reduce their 90% distribution requirement to preserve cash. Other studies may also provide REITs with non-cash deductions. These include repairs and maintenance studies, casualty loss studies under IRC Section 165(i) and abandoned project costs and tenant improvements that no longer should be on the books.
Reduce cash dividend: REITs are only required to distribute 90% of taxable income and are not required to distribute capital gains. By reducing the dividend to 90% of taxable income and retaining capital gains from the sale of property or investments, REITs will pay federal and state income tax on the retained income. Nevertheless, with the reduction in corporate federal rates to 21% in 2018, the tax is now generally lower compared to pre-2018 tax years and with recent changes to the NOL carryover rule, the remaining 10% can be offset by prior year NOLs through 2020.
Pay stock dividends: Revenue Procedure 2020-19, released on May 4, 2020, increases the percentage of stock with which publically offered REITs may satisfy their distribution requirements from 80% to 90%. This will give REITs flexibility to preserve their liquidity through these trying times. Dividends qualifying for this change must occur on or after April 1, 2020 through December 31, 2020.
Adjust dividend timing: Future year distributions can be used to offset current year income if the REIT needs to retain cash. If too much is “borrowed” from future years, the REIT may be required to pay a 4% excise tax. Private REITs can also make a “consent” dividend election to treat the cash as being distributed, and then, re-contributed. This cashless dividend allows the private REIT to take a dividends paid deduction, but keep any cash that would otherwise have been distributed to shareholders.
Nonaccrual reporting: If the collectability of interest or rent is substantially uncertain, there may be an opportunity for the REIT to cease recognizing income. Under the tax rules, a taxpayer is allowed to go to a “cash basis” method of accounting if collectability is highly unlikely. This opportunity should reduce the REIT’s non-cash income, and as a result, reduce the cash needed to make a distribution under the 90% distribution requirement.
Umbrella partnership real estate investment trust (UPREIT) partnership: Even in an economic downturn, REITs are looking to acquire properties. The UPREIT partnership is a great vehicle to acquire assets with little to no cash. Sellers also benefit by deferring gain and diversifying their holdings.
Long-term incentive plan (LTIP) awards: In lieu of cash compensation, REITs can issue ownership units in a REIT through an operating partnership. These units are called “long-term incentive plan” or “LTIP” awards. These awards are generally cashless and not taxable at issuance. Over time, the employees can receive dividends from the REIT in lieu of bonuses or other compensation.
Debt restructuring: REITs should work with lenders to understand the opportunities for reducing rates, extending terms, or reducing principal. Generally, for non-public debt, only the reduction in principal will be taxable. Nevertheless, cancellation of debt income is generally excluded from the 90% distribution requirement and gross income tests. In lieu of modifying debt terms, REITs may consider converting a portion of the debt to equity to get better terms or for cash management. Finally, keep in mind that under the CARES Act, multifamily borrowers with federally backed mortgages may be able to forbear payments up to 90 days.
State and local incentives: In addition to federal stimulus, more states and local municipalities are offering cash grants, subsidies and loans. To the extent a REIT receives cash from non-shareholders, the amount received may be taxable. Furthermore, it may not qualify as “good income” under the REIT rules.
Alternative income streams: REITs should consider alternative income streams. If the REIT has enough room in its 5% “bad income bucket,” the income stream should not be taxable to the REIT. If there is not enough room left in the 5% “bucket,” alternative income streams can go through a taxable REIT subsidiary (TRS), but will generally be subject to federal and state corporate income tax. Common alternative income streams include: solar credit monetization, management services, operation of cafeteria facilities, sale of land lots, advertising revenue or net profit sharing, insurance referral fees and other tenant services where the REIT can take a mark-up for providing the service. Finally, REITs should monitor how much value is added to the TRS, since the value of the TRS cannot generally be more than 20% of the REIT’s assets.
Section 1031: REITS should consider a Section 1031 exchange transaction to defer the recognition of gains from the sale of assets. The IRS released Notice 2020-23 which permits an extension of the identification period (45 days) and the replacement period (180 days) for transactions under section 1031. Taxpayers have until July 15, 2020 to complete these actions, originally due between April 1, 2020 and July 15, 2020.
Planning tip: By reducing dividends, working with lenders, leveraging UPREIT partnerships or a 1031 exchange and looking for new revenue streams, you can strengthen your cash position. Nevertheless, keep in mind these planning opportunities can impact your REIT status so be sure to consider the REIT tax rules before you execute a cash preservation strategy.
As the economy slows down, tenants may ask for rent concessions and other lease modifications. These changes to the lease arrangements may have taxable income and REIT testing implications, as discussed below.
Rent deferrals: Rent deferrals may provide tenants an opportunity to preserve cash, especially for retail tenants that have closed operation due to COVID-19. Even though rents are deferred, under the income tax rules of IRC Sec. 467, the income may still need to be reported by the REIT. The additional income can generally be excluded for the 90% distribution requirement. Any impact in change in revenues should be considered for compliance with the gross income tests and thresholds that could cause impermissible tenant service income (ITSI) activities to exceed 1% of gross receipts.
Short-term loans: REITs may be considering making short-term loans to tenants or service providers. Unless the debt is “straight debt,” the amount advanced by the REIT should be less than 10% of the value of the borrower. Such loans, are most likely not a “good asset” under the 75% real property test.
Investments in tenants: REIT may have the opportunity to receive investment in tenants in place of rent or debt forgiveness. Generally the exchange will be taxable to the REIT and the tenant. Also, REITs cannot participate in the net income of a tenant, so the investment may need to be held through a TRS. REITs need to consider whether the foreclosure election applies to the extent property received for debt.
Additional amenities and services: REITs may be considering providing additional services during this time to help tenants comply with federal and state mandated guidelines. REITs need to ensure proper due diligence to make certain the additional amenities and/or services are customary for the specific asset class and geographic location of the property. Otherwise, such amenities and services could be considered “impermissible tenant services income” under the federal REIT rules.
Planning tip: Keep in mind the various REIT rules and elections when providing aid to tenants, service providers and borrowers. REITs should also consider the effects the changes in revenue projection will have on the gross income and impermissible tenant service income (ITSI) tests.
As a result of recent stimulus packages and IRS pronouncements, several federal income tax laws have changed. These changes and the potential impact to REITs and TRSs are outlined below.
Change to filing date: Federal REIT returns and any income taxes are now due July 15, 2020. Some states follow this federal due date change, however, UPREIT partnerships generally are not able to take advantage of this deferred payment and filing date.
20% net operating loss (NOL) limit removed: NOL carryovers are now 100% deducible through the 2020 tax year. The deduction applies to any income remaining after the current year dividends paid deduction. REITs are not allowed to carryback NOLs, however, a TRS can carry back any NOLs created in 2018, 2019 and 2020 for a five-year period. Keep in mind that that changing stock values and market volatility could trigger a greater than 50% ownership change. Under the tax rules, such a change could limit a REIT or TRS NOL. If this is a concern, a REIT can take certain actions to minimize the risk of a majority ownership change by setting stock ownership limitations, shareholder right plans, or other programs.
Business interest deduction limitation increased from 30% to 50%: For the 2019 and 2020 tax years, the IRC Sec 163(j) interest limitation has been increased from 30% to 50% for REITs. Taxpayers may elect to use 2019 income in place of 2020 for the calculation. Additionally, REITs and UPREIT partnerships may now be able to make a late IRC Sec. 163(j) election or rescind an election previously made in 2018.
Qualified improvement property (QIP) depreciable life reduced: For REITs, QIP is typically any tenant improvement allowances recorded on the REIT’s books. For regular tax purposes, the QIP is eligible for bonus depreciation or 15-year depreciation. For dividend calculations, REITs must depreciate the QIP over 20 years.
Planning tip: Because some of these tax law changes are retroactive, REITs need to look at 2018 elections and determine opportunities to change elections, carryback TRS losses, or consider reducing the REIT’s dividends paid deduction in the future to take advantage of the removal of the 20% NOL limitation through 2020.
As a result of the FFCR and CARES Acts, REITs and management companies have the opportunity for payroll tax credits and other payroll-related benefits, as discussed below.
Employee retention credit: This $5,000 per employee refundable payroll tax credit is available to taxpayers that have partially or fully suspended operations or have experienced a significant decline in gross receipts over the prior year.
Emergency paid sick leave credit: This $2,000 to $5,110 per employee refundable payroll tax credit is available to taxpayers to fund time off related to COVID-19 sick pay.
Emergency paid family and medical leave credit: This $10,000 refundable payroll tax credit is designed to compensate employers for providing paid COVID-19-related family leave to employees, as required under the Emergency Family and Medical Leave Expansion Act.
Payroll tax deferral: This provision allows employers to defer their share of FICA payroll tax for March 27, 2020 through December 31, 2020 payroll period. Half of the tax payment is deferred until December 31, 2021 and the remaining is deferred until December 31, 2022.
Planning tip: Although these payroll tax relief provisions are attractive, they do have certain limitations depending on size of employer and whether the REIT takes advantage of a Small Business Association (SBA) loan.
REITs should consider various loan programs that have recently been enacted or come to light during this economic down turn. Below are some of the most popular loan programs.
Paycheck protection program (PPP): This is a small business loan issued by private lenders and fully guaranteed by the federal government. The loans are intended to cover eight weeks of payroll expenses, applied for at any date between February 15, 2020 and June 30, 2020. If at least 75% of the loan is used for payroll, it may be forgiven. The income from forgiveness is not taxable for U.S. tax purposes.
Emergency economic injury disaster loan (EIDL): Provided through the SBA, this is a loan of up to $2 million at a lower interest rate, with deferred; principal and interest. An EIDL is available to pay for expenses that could have been met by the business had the disaster not occurred. The CARES Act also establishes an emergency grant of up to $10,000 to EIDL applicants in advance of the loan to cover certain costs due to revenue loss.
Other loan programs: In addition to the above, there are other SBA and CARES Act loans that could be beneficial to REITs. Typically, these loans offer favorable lending terms, but have certain conditions and restrictions. Some states also have their own loan programs for taxpayers in need of liquidity.
Planning tip: Although the PPP and EIDL loan programs are generally not available to lessors of real estate, they may be available to management and other operating companies. Therefore, taxable REIT subsidiaries (TRSs) that have employees may benefit from these loan programs. Management companies of externally managed REITs may also qualify for these programs.
Recently enacted federal legislation and issued IRS rulings should provide REITs relief and assistance in maintaining operations during these trying times. As with most significant tax law changes and economic stimulus packages, there are potential issues that will need to be carefully navigated. Future guidance and clarification from the IRS and U.S. Treasury is likely needed to fully understand the impact these COVID 19 relief programs and opportunities have on REITs and the real estate industry.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.