Cash Crunch: COVID-19 may prompt REITs to explore non-cash distributions

As a result of significant operational downturns stemming from the coronavirus (COVID-19) pandemic, many tenants of real estate investment trusts (REITs) are struggling to pay rent and honor other terms of their leases. Consequently, REIT landlords are experiencing or will soon experience a negative effect on their own near-term cash flows and, ultimately, their overall financial condition. At the same time, however, these REIT landlords must also continue to distribute at least 90% of their taxable income to their stockholders annually or risk losing their REIT status. So, with cash flows beginning to dry up, what options do these REIT landlords have to satisfy their distribution requirement? This article proposes certain alternatives that REITs may consider so they can continue to make regular distributions to their investors and preserve their REIT status.

Distribution Requirement

Under Section 857(a) of the Internal Revenue Code of 1986, as amended (the “Code”), a REIT must generally distribute 90% of its taxable income, before taking into account the distributions paid deduction, to its stockholders annually. Additionally, because REITs generally qualify for a distributions paid deduction, if possible, a REIT will almost always endeavor to pay distributions equal to at least 100% of its taxable income before the distributions paid deduction to allow the REIT to avoid paying U.S. federal income tax at the REIT level.

Accrual Accounting and the Double-Edged Sword

Pursuant to Section 448 of the Code, which requires accrual method accounting for a corporation with average annual gross receipts exceeding $26 million for the three prior taxable years, most REITs must accrue rent income as it is earned, even if the REITs do not actually receive the rent because their tenants do not (or cannot) pay rent. Normally, REITs find this treatment favorable as it makes for stronger-looking financial statements despite a limited number of tenants that are unable to pay in the short-term. However, as the tenants of office buildings, warehouses, shopping centers, malls, hotels and other “non-essential businesses” shutdown as a result of COVID-19, REITs will find it quite unfavorable to be required to book income from tenants that are not actually paying rent.

Exceptions to the Distribution Requirement

If the economic recovery from COVID-19 takes several months, this situation could cause serious cash flow problems for REITs, which would still be on the hook to distribute 90% of their taxable income. Depending upon the particular REIT’s schedule for the payment of distributions, it may lack the cash from tenant rentals needed to pay such stockholder distributions. The Code provides very limited relief for “excess noncash income” which is in excess of 5% of the REIT’s taxable income before the distributions paid deduction. However, this “excess noncash income” is limited to certain back-loaded rents governed by Section 467 of the Code; gain from certain disqualified like-kind exchanges; original issue discounts; and cancellation of indebtedness income. The Code also provides, in certain circumstances, that a REIT may treat a distribution as being paid in a certain taxable year although it was actually paid in a subsequent year. Regardless, we believe that these limited forms of relief will not provide most REITs with the necessary assistance to survive significant near-term cash flow and liquidity problems.

Alternatives to Cash Distributions

Given the limited availability of other relief, REITs may want to consider looking at alternatives to paying distributions in cash.

Consent Distributions. As an initial matter, if a REIT’s stockholders agree, a REIT may pay a “consent distribution” which is a fictional distribution, treated as if a distribution were paid to the stockholders (which is taxable to the stockholders) and then contributed back to the REIT by the stockholders on the same day. We believe that the likelihood that a REIT’s stockholders would approve such a “consent distribution” would be minimal and would only be palatable to the stockholders of a REIT that is in the most dire of financial circumstances.

Cash and/or Stock DistributionsGenerally, distributions are paid in cash, though sometimes they are paid in property if circumstances dictate. The most obvious type of property available for a REIT to distribute would be its own stock. In addition to protecting a REIT’s cash position, a possible “public relations” benefit of stock distributions could be that, as the stock market has significantly devalued stocks of many companies in many industries as of late, a stock distribution could be touted as giving investors stock at a bargain price which may rebound as the economy itself rebounds from the pandemic. 

However, there are some key tax rules REITs should be aware of prior to making the decision to make a stock distribution. A distribution by a REIT of its own stock will not be treated as a “distribution of property” (and, therefore, it will not qualify as a distribution) unless it meets certain requirements of Section 305(b) of the Code. Generally, Section 305(b) will treat stock distributions as “distributions of property” if (i) the distribution is payable in stock, cash or other property at the election of the stockholder, (ii) the distribution is disproportionate among the stockholders, or (iii) the distribution has the effect of some stockholders receiving common stock and other stockholders receiving preferred stock. Note that only one of these conditions must be satisfied.

A REIT wanting to declare and make a stock distribution that will allow it to meet its distribution requirements and qualify for the distributions paid deduction will need to be careful to structure the stock distribution so that it qualifies as a “distribution of property.” Most REITs would likely seek to accomplish this through giving stockholders an election to receive stock or cash. Clearly, a REIT must place a limit on the amount of the cash that its stockholders may elect to receive; otherwise, most stockholders would likely elect cash such that the declaration of a stock distribution would not help in solving the REIT’s cash flow problem.

The IRS has provided a safe harbor for non-cash distributions issued by publicly traded REITs under Revenue Procedure 2017-45. The safe harbor allows that a distribution will be treated as a “distribution of property” for federal income tax purposes if (i) at least 20% of the total distribution is paid in cash (based upon fair market value), and (ii) stockholders have the option to elect to receive either stock or cash. Further, such stockholder election must have a mechanism for pro rata allocation of shares if stockholders oversubscribe for cash. The REIT must also use a formula for calculating shares that utilizes market price of the shares, uses data that is from within two weeks of the payment date, and corresponds as closely as practicable to the amount of cash to be received under the distribution with respect to the share.

Given the current economic climate and many enterprises’ desire to conserve cash, some REITs might wonder if a distribution eschewing the IRS’ safe harbor, composed of less than 20% cash (or even an all stock distribution) might be possible. Before 2008, multiple private letter rulings from the IRS confirmed that distributions of 80% stock and 20% cash would be treated as dividends. During the financial crisis beginning in 2008, the IRS released a series of temporary Revenue Procedures providing REITs a dividend received deduction safe harbor for distributions with a mix of 90% stock and 10% cash. NAREIT has already begun lobbying the IRS in a letter dated March 18, 2020, requesting the IRS issue similar guidance to allow 90%-10% stock-cash dividends to qualify for the dividend received deduction. Given the significant impact the COVID-19 crisis has had on the real estate sector and the potential to lead to a long-term economic downturn, we hope the IRS will consider reinstating a temporary 90%-10% policy so that REITs need not risk losing their REIT status for making distributions in amounts outside of those set forth in Revenue Procedure 2017-45’s safe harbor. In the meantime, because the safe harbor is generally viewed as a generous interpretation of the statute by the IRS for REITs, paying a dividend of less than 20% cash without a private letter ruling would likely be imprudent considering the high stakes of maintaining REIT status.

Regardless of the proportion of stock issued in a distribution, the REIT should undertake the proper corporate governance procedures with respect to the distribution. At a minimum, a REIT should ensure that its Board of Directors fulfills its fiduciary obligations and exercises its business judgment by duly considering, reviewing and approving (i) the distribution as being in the best interests of the REIT and its stockholders, (ii) the mix of cash and stock that will be issued in the distribution, (iii) the cash reserves and financial condition of the REIT both before and after the distribution, (iv) the perception of the distribution in the marketplace and, if applicable, the corresponding impact upon the trading price of the REIT’s stock, and (v) the process by which the distribution will be conducted.

With respect to the procedures necessary to effectuate the distribution, if it will involve a mix of cash and stock, a REIT must consider how its stockholders will make their respective elections regarding the form(s) of consideration they wish to receive.

Property DistributionsIf a REIT does not want to cause its stockholders to suffer dilution by issuing stock, another non-cash option is the distribution of actual property (real estate). This alternative could be a particularly attractive option if a REIT has certain property(ies) or even a portfolio that it wishes to divest and the (likely non-public) REIT has a stockholder base small enough to make such a distribution manageable. 

For a distribution of property, the distribution would generally need to be made to the stockholders on a pro rata basis. A non-pro rata redemption that is not “essentially equivalent to a distribution” would not satisfy the Code’s distribution requirements.

Conclusion

With no known end to the COVID-19 pandemic in sight and the financial and capital markets in turmoil, REITs would be well advised to evaluate immediately their current cash reserves, access to readily available capital, liquidity and overall financial condition so that they may make informed decisions when planning for their continued viability. In times such as these, the accounting truism has never been more accurate: “Cash is King.” By preserving their cash (and possibly their REIT status) with stock or property distributions, REITs with tenants operating “non-essential businesses” could position themselves to weather the COVID-19 storm.

If you have any questions or wish to explore non-cash distributions for your REIT, please contact any of Marc AdessoShane MorrisWes Scott or Nicole Dressler.