Why Some REITs Distribute 100% of Taxable Income
The 90% test generally sets the distribution floor for REIT qualification, and it applies to REIT taxable income excluding net capital gain. Taxable income left undistributed above that floor can be taxed at corporate rates, so some REITs target distributions of at least 100% to reduce potential corporate tax on retained income. The price is less retained cash for investment and for portfolio growth.
What the 90% test measures and what it leaves open
The qualification test looks at REIT taxable income, determined without regard to any net capital gain. It sits beside the asset and income tests, and a REIT has to satisfy all of them to keep its status.
The denominator is a tax figure. It is built from the REIT’s tax return, so it can differ from net income under accounting rules and from cash flow.
A REIT that pays out 90% of that figure generally satisfies the distribution test. The remainder is still taxable income, and the test says nothing about whether tax is due on it.
Where the undistributed slice picks up corporate tax
Distributions of taxable income and capital gains to stockholders can reduce a REIT’s federal corporate income tax exposure. Income it keeps can be taxed at corporate rates.
That is the whole reason a payout target can sit above the qualification floor. Distributing less than 100% can leave part of taxable income subject to corporate tax, while a higher payout can reduce the amount exposed to that tax.
Every REIT also faces a second layer. A 4% nondeductible excise tax applies to the amount by which calendar-year distributions fall short of required amounts: 85% of ordinary income, 95% of capital gain net income, and any shortfall carried over from earlier years.
The excise tax is therefore a separate hurdle from both the 90% qualification test and the corporate tax on retained income. A payout that clears the qualification floor can still trigger it if it falls short of the 85% and 95% calendar-year amounts.
“The Fund will be subject to regular corporate income taxes on any undistributed REIT taxable income each year.”
How issuers state the target
A mortgage REIT’s stated distribution policy includes at least 90% of REIT taxable income and a target of at least 100%. A healthcare REIT’s stated target is at least 100% of taxable net income for the coming year.
Both statements pair the floor with a higher aim. The floor addresses the distribution requirement for REIT status, and the higher aim can reduce corporate tax on undistributed income.
Other REITs recite only the 90% requirement in their risk language. A filing that recites the minimum does not by itself reveal what the company actually pays.
What a full payout takes from the balance sheet
Every dollar distributed is a dollar unavailable for the business. Required distributions reduce the funds a REIT has for investment and for growing or reworking its portfolio.
Taxable income that stays inside the company funds those activities without a new equity or debt raise. A REIT that pays out 100% of taxable income still keeps the cash from depreciation and other non-cash deductions, because those reduce taxable income but not cash. What it cannot keep is the taxable income itself, so growth beyond that retained cash has to come from outside capital, with the pricing and timing that come with it.
The decision therefore pairs a tax calculation with a capital plan. The tax saved on the retained slice is weighed against the cost of replacing the retained cash from another source.
Worked example: a 90% payout against a 100% payout on $10,000,000 of taxable income
All figures are hypothetical. A REIT reports taxable income of $10,000,000. For simplicity, assume taxable income equals cash and apply an illustrative 25% corporate rate to any income left undistributed. The rate is an example input, and the example leaves out the excise tax and any other levy.
Base case, 90% payout. Distribution is $10,000,000 multiplied by 90%, which is $9,000,000. The undistributed slice is $10,000,000 minus $9,000,000, or $1,000,000. Illustrative tax is $1,000,000 multiplied by 25%, or $250,000. Cash retained after tax is $1,000,000 minus $250,000, or $750,000.
As a check, $9,000,000 plus $250,000 plus $750,000 equals $10,000,000. The tax equals 2.5% of the taxable income.
Alternative case, 100% payout. Distribution is $10,000,000 multiplied by 100%, which is $10,000,000. The undistributed slice is $10,000,000 minus $10,000,000, or zero. Tax is zero multiplied by 25%, which is zero, and retained cash is zero.
Now suppose the REIT wants to put $1,000,000 into a redevelopment. In the base case, $750,000 of retained cash covers part of it and $1,000,000 minus $750,000, or $250,000, comes from outside. In the full payout case, the retained cash is zero and the outside need is $1,000,000 minus zero, or $1,000,000.
In this hypothetical comparison, distributions are $1,000,000 higher in the full payout case, and illustrative corporate tax on retained taxable income is zero. It also holds $750,000 less cash and must raise $750,000 more externally. The comparison turns on what that outside capital costs.
The zero retained cash in the full payout case follows from the simplifying assumption that taxable income equals cash. A real REIT that distributes all of its taxable income still retains its depreciation and other non-cash deductions, so its outside need would be smaller than $1,000,000.
Mistakes in reading REIT payout figures
Applying the 90% to net income misstates the test. The requirement is measured on REIT taxable income without regard to net capital gain, and depreciation, timing items and other tax adjustments can make that figure differ from accounting earnings.
Treating a funds from operations or cash flow payout ratio as the test result mixes denominators. A company can pay 100% of one measure and a different percentage of taxable income.
Income retained above the distribution floor can remain subject to corporate tax. Qualification and tax on retained income are separate outcomes.
Treating a 100% target as spare cash overlooks the funding side. Distributions reduce the funds available for investment and portfolio growth, so the payout and the capital plan move together.
Checklist questions for reading a REIT distribution policy
Check the denominator used for the stated payout. REIT taxable income, excluding net capital gain, is generally the denominator for the distribution qualification test.
Distinguish the minimum from a stated aim in the filing. A stated aim of at least 100% can reflect a policy of limiting taxable income retained by the REIT.
Calculate how much taxable income would remain undistributed at the stated payout. That slice is the amount exposed to corporate tax.
Check whether the stated payout meets the excise tax thresholds. The thresholds are tested per calendar year and include income carried from earlier years.
Identify the funding that replaces the retained cash. Required distributions reduce the funds available for investment and portfolio growth.
Identify whether the payout ratio quoted by the company uses taxable income, earnings or cash flow. The measures can differ, so a percentage tied to one cannot be read as a percentage of another.