REIT Question
I believe I already know the answer to this but was looking for confirmation.
So obviously companies wanting to be tax structured as a REIT have to meet certain criteria:
- Minimum of 100 shareholders
- Invest 75% of assets in real estate assets
- Obtain 75% of gross income from rents
- Pay out at least 90% of its taxable income
(there are more requirements, but these are some of the main ones)
I want to focus on the last point "Pay out at least 90% of taxable income". This is an oversimplification but, Taxable Income would generally be derived from Rents - Operating Expenses - Interest. However, if a REIT sells assets at a gain or a loss, that would also contribute to taxable income. My question is, do these gains also get picked up in the requirement that they pay out 90% of taxable income?
I believe the answer is yes, but just want to confirm my logic makes sense.
When I see REITs make a big portfolio sale with a gain, I have not seen the dividend increase, even though I believe portfolio sales should be counted in the requirement to pay out 90% of taxable income. Is this because REITs typically pay out more in dividends* than their net income, so instead of having retained earnings most have a contra equity account "dividends in excess of net income" or "earnings less than distributions". Since they have already paid out more than 90% in the past and have a big build-up of over distributions, are REITs taping into these contra accounts when they make big sales?
*(REITs typically pay a dividend per share that is higher than their EPS. EPS includes depreciation, a non-cash expense, so not the best metric for cash flow available for distributions. Dividend more based on AFFO.)
Yes - you're correct that gains on sale are part of taxable income and would need to be covered in that 90% distribution requirement. Also correct in your note that it is taxable income, not net income, that is subject to 90% distribution requirement (so simple EPS * 90% doesn't necessarily equal required distribution). Not a tax expert, but I believe that the requirement is annual, not necessarily cumulative (so I couldn't pay out 200% in year 1 and 0% in year 2), but I'd have to defer to an expert there. That generally won't apply since most big (listed, covered) REITs try to keep regular distributions smooth and sloping upward.
Often, if you have an asset sale that results in a large gain the REIT will pay a special dividend to shareholders to meet their distribution requirement. This will generally be a one-time distribution. Alternatively, REITs can use 1031 exchanges to defer the gain and reduce taxable income, or sell other assets at a loss to offset the tax gain (rarely see this since REITs don't like to admit losses for optics, and most importantly, losses, but not gains, hit FFO which isn't a great story and often negatively impacts CEO comp).
Thanks, that makes sense! In the back of my mind I was thinking 1031 exchange but I don't think I was mentally separating the likely difference between GAAP accounting and what a REIT would file with the IRS.
This might be a tax heavy follow-up question, but I assume what would be captured as a "gain" would differ between GAAP and tax return (overstated gain on GAAP)? From a GAAP perspective you would depreciate each year, and in theory could sell at the same price you bought for, but record a "Gain on sale of property" for accounting purposes, but not actually have a tax liability for that "Gain" since I also don't think that accounts for the potential 1031. From an IRS tax perspective, I'm guessing this gets treated differently and a 1031 exchange can occur.
So I'm definitely not a tax or GAAP expert, but I'll give this is a shot. The gain would differ because your tax books and your GAAP books will have a different net basis for the real estate you are disposing (due to differences in depreciation schedules, treatment of capitalizable costs, previous 1031 exchanges etc.).
So for instance, you buy a property for $10 in cash, and after five years, your GAAP basis is $7 and tax basis is $6.50. You sell it for $12. If you don't perform an exchange, your GAAP basis gain on sale (which hits net income, eps, etc) would be $5, and your tax basis gain on sale would be $5.50. If you do a 1031 exchange and buy another property for $12, your GAAP basis gain on sale would still be $5 - so no impact to company's reported earnings - but you would not have a tax basis gain on sale. In this case, your GAAP basis on your new property would be $12 and your tax basis would be $6.50. So you can see how this can cause the delta between GAAP and tax books to be significant.
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