If your REIT is concerned about the 90% dividend distribution requirement for the 2020 tax year, good news: Several options exist, from QIP treatment, analyzing tenant build-out costs, cost segregation studies, throwback dividends, and noncash distribution for private REITs. We explain.
Treatment of qualified improvement property
The CARES Act fixed a drafting error in the Tax Cuts and Jobs Act that impaired the ability to depreciate qualified improvement property (QIP). QIP is any improvement to the interior of a nonresidential building, which doesn’t include improvements made prior to the building being placed in service.
Taxpayers are eligible to claim 100% bonus depreciation on QIP placed in service during 2020. As a result, reviewing cost allocations for building improvements has taken on additional importance. Also, the correction made by the CARES Act is retroactive, allowing taxpayers to file for a change in accounting method to claim bonus depreciation on QIP placed in service during 2018 and 2019. The benefit of this retroactive correction can be captured for the 2020 tax year by filing for a change in accounting method for that year.
Reviewing cost allocations for building improvements has taken on additional importance.
REITs that otherwise would have seen the deductibility of their interest expense limited often made elections out of Code section 163(j). The drawback for making this election is that property eligible for 100% bonus depreciation applicable to QIP can no longer claim bonus depreciation on such property. However, filing a change in accounting method for this property still allows the benefit of shortening the recovery period from 39 to 20 years.
Allowing taxpayers to file for a change in accounting method to claim bonus depreciation on QIP placed in service during 2018 and 2019.
Analyzing tenant build-out costs for potential expensing
The tangible property regulations (TPRs) issued in 2013 added a “unit of property” measure when determining if costs incurred with respect to a building require capitalization. Under these expansive rules, the materiality of the costs isn’t generally measured with respect to the tenant space but to the building as a whole (or individual building systems). These regulations provide a different analysis for determining capitalization, when compared to the prior tax law. Utilizing the TPRs can, at times, permit the expensing of large tenant build-out costs, allowing a deduction comparable to 100% bonus depreciation.
Cost segregation studies
Cost segregation studies analyze building costs to determine if some of the costs that would otherwise be classified as building costs can instead be allocated to asset categories that have shorter recovery lives (5, 7, 15, or 20 years). Assets with recovery lives of 5, 7, and 15 years are often eligible for bonus depreciation. Studies completed during 2021 for the 2020 tax year can permit significant tax depreciation for the 2020 tax year and reduce the distribution requirement.
Cost segregation studies can be completed for projects placed in service during 2020, or for projects placed in service in previous years, to capture the retroactive benefit within the 2020 tax year. In order for the studies to capture the benefit from projects placed in service in years before 2020, a change in accounting method will need to be filed with the 2020 return.
In exchange for paying a 4% excise tax, REITs can elect to take dividends declared and paid in 2021 as paid in 2020 for purposes of the 2020 dividend distribution requirement. Congress created the 4% excise tax to reconcile the fact that the REIT is getting a benefit in one year in the form of a dividends paid deduction, but the shareholders recognize the income for the throwback dividends in the following tax year.
Noncash distribution option for private REITs
If a private REIT can gain authorization from its shareholders, it can pay “consent dividends” to meet its 2020 dividend distribution requirement. For tax purposes, the REIT is deemed to have paid — despite no cash outlay — the amount of the consent dividends, which the shareholders are then deemed to have contributed back to the REIT’s capital. The shareholders report the income as if the dividend had been paid to them in 2020.
REITs concerned about meeting the 90% dividend distribution requirement for 2020 have several noncash options available. Accelerating deductions via the treatment of QIP, analyzing tenant build-out costs, and cost segregation studies can lower taxable income of the REIT, resulting in lower cash distribution requirements. Throwback dividends, and noncash distributions for private REITs, can potentially eliminate the shortage in 2020 and? the distribution requirement that might otherwise exist. Each of these strategies or combinations of several, provide REITs a rare opportunity to mitigate a 2020 issue in a subsequent year.
As always, if you have any questions, give us a call.