COVID-19 Impacts on REITs and Mitigation Strategies

For assets acquired with borrowing proceeds, a REIT may not rely on the “temporary new capital” exception, which allows stock or debt instruments acquired with the new capital to be treated as good real estate assets for one year (and generate good income for the income tests). The rule only applies to non-DRIP equity capital or capital raised in public offerings of debt instruments with at least a five-year maturity. It does not apply to assets or income derived from other borrowings.

Cash and cash items that are good assets for REIT purposes include bank time and demand deposits, CDs with maturities of one year or less, and money market bank accounts. Money market mutual funds are an additional option since after years of uncertainty, Rev. Rul. 2012-17 confirmed the status of such funds as qualifying “cash items.” Note, however, that this ruling does not apply to other debt or equity mutual funds, and other instruments such as bankers’ acceptances and repurchase agreements are not treated as cash or cash items. (Arguments that repurchase agreements should be qualifying cash or cash items have not yet been accepted by the IRS in formal REIT guidance.)

These distinctions make it important to check whether any financial assets acquired with borrowed capital, even if they are treated for accounting purposes as “cash equivalents,” could be treated as securities (i.e., financial instruments that are not good assets for the 75% asset test) for REIT asset test qualification purposes and make them subject to the securities asset tests. While it may be unlikely that short-term investment even of significant borrowing proceeds will create issues for a REIT in meeting the 75% real estate assets test, an unwary REIT might have more risk under the 5% asset test. For this test a REIT cannot have more than 5% of its total assets in the securities of a single issuer. Thus, the acquisition of a large position in any one issuer’s financial instruments may risk violating this test if they are classified as securities. As a result, it may be necessary to split the cash between different financial assets or accounts, and it may also be appropriate or required for non-REIT purposes. The 10% asset tests should also be considered. These tests are violated if the REIT holds securities possessing more than 10% of either the voting power or the value of the outstanding securities of any one issuer. Although the short-term assets considered in this discussion are typically issued by large financial institutions and generally should not risk violation of the 10% voting and value asset tests, the REIT should still document that it has confirmed that any securities in a single issuer represent less than 10% of the issuer’s securities by voting power or value (or are otherwise exempted, such as debt securities that qualify as “straight debt”).

If asset test issues are identified, the REIT should act as soon as possible to remedy the situation, and in no event later than the end of the calendar quarter when the asset was acquired (which is when the REIT asset tests are measured). If a violation occurs, the REIT has 30 days after the end of the quarter in which the asset was acquired to remedy the situation without losing REIT status. If the violation is not identified and remedied during this 30-day period, the REIT will have to rely on more restrictive relief provisions that, for the situations addressed here, will likely require that the REIT (i) demonstrate “reasonable cause” and not willful neglect to excuse the failure, (ii) dispose of enough of the asset to remedy the failure within a specified time period, and (iii) pay a significant penalty.

Tenant Lease Workouts
With many tenant businesses shut down suddenly due to COVID-19, a REIT may agree to provide lease forbearance, including deferral of all or a portion of rent payments through a certain period, or even a partial forgiveness of some rent payments. A REIT must be careful to craft such rent deferrals and forgiveness to align with REIT rules.

“Good” income for the REIT income tests means that rents cannot be based upon the tenant’s income or profits, except for percentage rents based upon gross income or receipts. Further, once a lease is signed, the percentages or the underlying rents must not be renegotiated in a manner which has the effect of basing the rents on net income or profits. A REIT dealing with a distressed tenant will have a legitimate business purpose to renegotiate rent payments to reflect rent deferrals or partial forgiveness to avoid the costs of a tenant default, but such deferrals or forgiveness should only be based on fixed amounts or percentages of the rent or tenant gross income or receipts. The REIT should avoid basing any rents or payments on the tenant’s net income or current cash flow. Doing so risks disqualification of all of the tenant’s rent for purposes of the income tests.

Rent deferrals may raise phantom income issues for REITs since accrual basis landlords may still be required to recognize the deferred rents in income currently notwithstanding that the obligation to pay the accrued rent has been deferred. REITs should also consider whether revised lease terms could cause a lease to be subject to the provisions of section 467, which address stepped rents, rent deferrals, and similar provisions. Under those rules, restructured rents may still be accrued currently for tax purposes and trigger taxable income and the associated distribution requirement without the cash to do so. Such considerations are particularly acute with the COVID-19 situation, as it may be necessary to provide deferral or other relief to many tenants as opposed to the ordinary situation of a limited number of distressed tenants at any one time.

Although these issues require careful planning, rent deferrals no longer risk a possible violation of the 10% asset test by value. In 2004, Congress clarified that section 467 rental agreements (other than with a related party) and any tenant real estate rent obligations (such as occur in rent deferrals) are not treated as securities for purposes of this asset test.

REIT Debt Restructurings
The REIT itself may be put in the position of needing to negotiate a debt workout with its own lenders. If so, the REIT should be aware that certain significant modifications to the terms of such debt may result in a taxable exchange of the debt, resulting in potential cancellation of indebtedness income (or COD income) to the REIT. Section 108(e)(9) of the Code provides that COD income is ignored for income test purposes and the REIT distribution requirements will be reduced to the extent COD income is included in excess noncash income. However, even though the COD should not raise potential REIT income test violations, the REIT could potentially be subject to tax on the COD income unless the REIT meets one of the applicable exceptions to recognition of COD income.

Distribution Issues and Options to Conserve REIT Cash
REITs are required to distribute their income to their shareholders and are entitled to income tax deductions (the dividends paid deduction) for the taxable dividends that they pay to shareholders. Due to reduced rent payments by tenants during and perhaps after the COVID-19 pandemic, a REIT may see its cash flow greatly reduced and may need to conserve cash. There are several options available to REITs that may allow them to meet their distribution requirements while deferring or reducing cash distributions to shareholders.

• Distribute between 90% and 100% of REIT Taxable Income. Under the section 857(a)(1) REIT distribution test, every year a REIT must distribute at least 90% of its REIT taxable income (less net capital gains and as computed prior to the dividends paid deduction generated by the distribution, and minus “excess noncash income,” which among other items includes noncash income arising from section 467 rental agreements and cancellation of debt (COD) income to the extent they exceed 5% of REIT taxable income prior to the subtraction) plus 90% of any after-tax foreclosure property income. A REIT may also choose to, and usually does, distribute its net capital gains, and shareholders may obtain long-term capital gain treatment for those dividends. The REIT obtains a dividends paid deduction for its taxable distributions, which zeroes out its taxable income if the dividends amount to 100% or more of its REIT taxable income before the deduction. Although a REIT may conserve cash by distributing less than 100% but more than 90% of REIT taxable income, and/or retain its net capital gains, few REITs ordinarily choose to do this since the REIT would then pay corporate income tax at both the federal and state level on the difference between REIT taxable income and the amount distributed. Shareholders receive a credit for any tax paid by the REIT on net capital gains, but many shareholders are otherwise tax-exempt, and the REIT still bears the burden of the tax. As noted above, any excess noncash income is not included in the REIT distribution requirement, but as with distributing less than 100% of REIT taxable income, such income remains subject to corporate tax at the REIT level.
• Deferred Dividends. Instead of retaining income subject to corporate tax, a REIT can defer payment of some or all of its dividends up to the end of the taxable year. In fact, under section 857(b)(9) of the Code, a REIT can further defer dividends for one additional month by declaring a dividend in the last quarter of a taxable year payable to shareholders of record in that quarter and pay the dividend in January of the following year. These “January dividends” may permit a REIT to defer payment of some or all of its REIT distribution requirement for more than the entire taxable year, with the dividends being treated, for purposes of both the REIT distribution requirement and shareholder taxation, as having been paid on December 31 of the prior year to which they relate.
• Consent Dividends. A private REIT may have the option of conserving cash through a “consent dividend” under section 565 of the Code. In simple terms, a consent dividend involves common shareholders executing consents that treat them as receiving a specified dividend in cash from the REIT as of December 31 and immediately recontributing the cash to the REIT. Typically, this process is only practical for private REITs with a limited number of shareholders, and generally all of them must agree to execute the consents in order to avoid risk of violating a preferential dividend rule that is applied to private REITs that would disqualify the REIT dividends for the dividends paid deduction.
• Section 858 Dividends. A REIT has a further option to pay section 858 dividends, which can be paid up to a full year after the end of the tax year to which they apply. These dividends must be paid in adherence with certain procedural rules which can make them a trap for the unwary. However, if those rules are satisfied, the REIT can elect to treat the dividends paid the following year as dividends for the current year for purposes of the REIT distribution requirement. The shareholders are taxed in the next year based on the date received. The downside of this option compared to deferral within the same taxable year or January dividends is that the REIT may be subject to a nondeductible 4% excise tax on these section 858 dividends to the extent that the REIT relies on these dividends to satisfy more than a limited portion of its REIT distribution requirement (the 4% excise tax being the equivalent of an interest charge imposed on the deferral).
• Cash/Stock Dividends. Finally, a publicly offered REIT (i.e., one that is required to file annual and periodic reports with the SEC under the Securities Exchange Act of 1934) can choose to make taxable dividend distributions partially in cash but mostly in stock (“cash/stock dividends”), allowing the REIT to avoid paying cash dividends for most of its REIT distribution requirement. In this procedure, the REIT generally permits its shareholders to elect to receive their dividends in either cash or stock, or a combination of the two, with a limit on the maximum percentage of the distribution that can be made in cash to all shareholders in the aggregate. Because the shareholders have this cash or stock choice, and some shareholders may receive common stock while others receive cash, the shareholders are taxed on the full value of the cash and stock received, allowing the REIT to count the entire value of the cash/stock dividends paid as a taxable dividend for purposes of the REIT distribution requirement. The IRS originally approved of such cash/stock distributions in several private letter rulings in the early 2000s, generally as long as the REIT set the aggregate cash limit at a minimum of 20%. Thus, if the minimum 20% limit was specified and all shareholders elected cash, the REIT would pay out 80% taxable stock dividends to each shareholder in addition to 20% in cash. If some shareholders did not elect to receive cash, then the cash-electing shareholders would receive a higher amount of cash, theoretically up to 100% if relatively few shareholders elected cash (although that rarely occurs).
  • During the financial crisis beginning in 2008, the IRS issued several revenue procedures implementing and extending rules that permitted all REITs with stock publicly traded in the U.S. to issue cash/stock dividends and allowed the aggregate cash limit to be as low as 10% (allowing 90% of the distribution to be made in REIT stock). Although those revenue procedures expired in 2012, the IRS subsequently published Rev. Proc. 2017-45 that permanently allowed publicly offered REITs to issue such cash/stock dividends but reverting to the aggregate cash limit of at least 20% as was allowed in the original letter rulings. It is also worth noting that the safe harbor of Rev. Proc. 2017-45 only applies to publicly offered REITs. This suggests that a private REIT seeking to utilize this strategy will have significant risk regarding its tax position.
  • Proc. 2017-45 remains in effect. In fact, on March 19, 2020, NAREIT sent a letter to the Treasury requesting that it update and modify the safe harbor of Rev. Proc. 2017-45 by temporarily reinstating the lower 10% aggregate cash limit that was in effect during the 2008 – 2012 period to provide REITs with more flexibility in conserving cash during the period affected by the COVID-19 pandemic. The IRS has to date not responded to this request, so the minimum cash limit currently remains at 20%. Even if the lower 10% limit is not approved, however, cash/stock dividends can provide a powerful option for publicly offered REITs to conserve cash in these difficult times. However, the REIT must be cognizant of potential dilution if its stock value has dropped significantly. Also, stock price volatility can be an issue since a REIT wishing to use a multi-day price average prior to payment of the cash/stock dividend can at most average stock values over a two-week period ending as close as practicable to the payment date.

  Like-Kind Exchange Issues
  Many REITs use section 1031 like-kind exchanges to defer tax gain on disposition of their properties. However, section 1031 transactions require adherence to strict time deadlines to designate properties and close on the transaction. In a March 23, 2020, letter, NAREIT and other real estate groups requested that the IRS temporarily extend the time limitations for investors to designate and complete a section 1031 transaction because of the difficulty under the current COVID-19 restrictions to take the required actions within the necessary time frames. As of now, the IRS has not responded to this request, so it is uncertain whether and when relief may be provided.

  Conclusion
  The COVID-19 pandemic has imposed sudden and unique disruptions to U.S. and world economic activity that may severely affect REITs and their tenants going forward for an unknown period of time. Accordingly, REITS must be aware that REIT actions taken in response to the potential impact of these disruptions have implications on maintaining REIT status that must be managed. Fortunately, there are also methods available that provide tools to mitigate some of these impacts and allow REITs to successfully manage their way through this difficult period.

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