REIT Taxable Income Defined
REIT taxable income is the tax-basis income figure that a REIT’s required distribution is measured against. To keep REIT status, a REIT generally must pay dividends equal to at least 90% of it, determined without regard to the dividends-paid deduction and excluding net capital gains. It can differ materially from GAAP net income in both timing and amount, so a payout sized off the financial statements can miss the real test.
The base of the 90% test and what it leaves out
The distribution requirement is a percentage of REIT taxable income. Earnings per the financial statements and funds from operations play no part in the base.
Two features of the base matter. First, it is determined without regard to the dividends-paid deduction, so paying a dividend cannot shrink the number the payout is measured against. Second, net capital gains are excluded from the annual 90% measure.
The tax form wording approaches the same test from the deduction side. The deduction for dividends paid must generally equal or exceed 90% of specified taxable income, adjusted for foreclosure-property income and excess noncash income.
Why tax income and GAAP net income part ways
GAAP net income and REIT taxable income can differ materially in the timing and amount of income and loss recognition. Each ledger follows its own recognition rules, so a quarter that looks flat on the financial statements can carry a very different tax result.
A payout ratio computed on GAAP earnings therefore has a denominator that the requirement does not use.
The adjustments named in the tax form point the same way. Foreclosure-property income and excess noncash income modify the figure the 90% threshold is applied to, so the base is a tax computation with its own adjustments.
How the dividends-paid deduction ties payout to tax
A REIT is permitted to deduct dividends paid to its stockholders in determining its taxable income. When distributions equal or exceed U.S. taxable net income, a REIT generally expects to owe no U.S. income tax.
The deduction does two jobs. It sets the tax bill, and it is the quantity compared against the 90% threshold.
The base for the threshold stays before the deduction. Using after-deduction income as the denominator would shrink the requirement with every dollar paid, a circular result.
“Under the REIT operating structure, we are permitted to deduct dividends paid to our stockholders in determining our taxable income.”
Paying above the floor
Ninety percent is a minimum. Some issuers state that they expect to distribute at least 100% of taxable net income.
A payout at or above 100% lines up with the tax outcome above, where distributions that equal or exceed taxable net income generally leave no U.S. income tax.
Worked example: one REIT, two taxable income outcomes
The figures are hypothetical and illustrative. A REIT reports GAAP net income of $14,000,000 and has no net capital gains, no foreclosure-property income and no excess noncash income. Its dividend policy sets the payout at 90% of GAAP net income.
The policy dividend is $14,000,000 multiplied by 90%, which is $12,600,000.
Case A: timing differences push REIT taxable income, before the dividends-paid deduction, up to $20,000,000. The 90% requirement is $20,000,000 multiplied by 90%, which is $18,000,000. The $12,600,000 dividend falls $5,400,000 short.
Case B: the GAAP result is the same, but REIT taxable income comes in at $12,000,000. The requirement is $12,000,000 multiplied by 90%, which is $10,800,000. The $12,600,000 dividend clears it by $1,800,000.
Same company, same GAAP earnings, same dividend. The pass or fail result moved because the tax measure moved.
Common mistakes in reading REIT taxable income
Using GAAP net income as the base is the most direct error. The two measures can differ materially in timing and amount, and Case A above produces a $5,400,000 gap that a GAAP-based payout would leave unfunded.
Counting net capital gains in the base overstates the requirement. The annual 90% measure excludes them, so a year with a large gain does not raise the required dividend by 90% of that gain.
Subtracting dividends from income before applying 90% understates the base. The base is determined without regard to the dividends-paid deduction, and the test compares the deduction to that pre-deduction figure.
Reading the rule as 90% of earnings or of cash flow mislabels it. The requirement is a share of REIT taxable income, adjusted for foreclosure-property income and excess noncash income.
Questions for checking a REIT taxable income calculation
Is the starting figure REIT taxable income, with no financial statement line standing in for it? The distribution requirement is written against the tax measure.
Is the base measured before the dividends-paid deduction? The deduction is the numerator of the test and cannot also reduce its denominator.
Are net capital gains excluded from the 90% base? The annual measure leaves them out.
Have foreclosure-property income and excess noncash income been adjusted for? The general threshold carries those adjustments.
How large is the gap between GAAP net income and taxable income, and what drives its timing? Recognition differences can be material in both amount and timing.
Does the dividend compared to the threshold sit on the same base as the threshold? A GAAP-based dividend measured against a tax-based requirement mixes two yardsticks.
Does the planned payout sit at the floor or above it? Some issuers state an expectation of distributing at least 100% of taxable net income.