When you dig into how REITs operate, they become fairly complex investments. Most of this isn’t as important for investors but is important for REIT operators. We will look at two specific restrictions or rules that REITs must follow.
REITs operate under certain restrictions, which afford REITs specific tax benefits. One of those restrictions is that REITs must distribute (i.e., dividends) 90% of their taxable income to investors. If there are no earnings to distribute, the distribution is considered a return of capital and not taxed. Paying 90% of income disqualifies the REIT from paying corporate taxes.
For investors, there may also be tax advantages from REIT dividends. Dividends typically come in two categories — regular and qualified dividends. Regular dividends are taxed at the investor’s ordinary income tax rate. Qualified dividends are generally taxed at the capital gains rate.
Return of capital might be thought of as a dividend, but as mentioned above, it is the return of principal and not taxed.
The next two sections get into the main topics of this article, which highlight two more REIT restrictions.
The 10% rule is related to safe harbor rules. When a REIT sells property as “inventory,” it can avoid being categorized as a prohibited transaction by meeting several requirements. One of those requirements is the 10% rule1.
This rule is based on the fair market value (FMV) of all REIT properties at the beginning of the year. At the beginning of the year, properties sold as inventory cannot exceed 10% of the FMV of the REIT’s assets.
This rule was introduced with the Tax Cut and Jobs Act (TCJA) and is part of Section 163(j) of the IRS Code. It states that a REIT may not deduct business interest expenses that exceed 30% of adjusted taxable income.
REITs use debt financing, where the business interest expense comes in. Under the TCJA, the business interest expense deduction is a mechanical computation.
Note that the 30% rule seems to be more dynamic than static. In 2019 and 2020, the limit was raised from 30% to 50% by the Coronavirus Aid, Relief, and Economic Security (CARES) Act. In 2021, the business interest expense calculation made the deduction more restrictive2.
The above two rules pertain mainly to REIT operators rather than investors. Investors will mostly be concerned about researching a REIT as a viable investment and the taxation of their distributions.