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IRS Provides Distribution Relief for REITs and RICs

Posted on May 5, 2020

The IRS has temporarily modified the stock-cash distribution requirements for specified real estate investment trusts and regulated investment companies, but further relief may still be needed.

In Rev. Proc. 2020-19, 2020-22 IRB 1, issued May 4, the IRS reduced the safe harbor minimum required aggregate amount of cash that shareholders may receive to 10 percent of the total distribution for the distribution to qualify for tax treatment under section 301.

The guidance was issued so that REITs and RICs could conserve capital, given the “need for enhanced liquidity during the current period of economic disruption,” according to the IRS.

The temporary modification applies only to “distributions declared by a publicly offered REIT or publicly offered RIC on or after April 1, 2020, and on or before December 31, 2020.”

The guidance specifically modifies Rev. Proc. 2017-45, 2017-35 IRB 216, by reducing the “cash limitation percentage” from no less than 20 percent to no less than 10 percent.

To qualify for special tax treatment — distributed earnings are taxed only at the investor level — REITs and RICs must, among other things, distribute at least 90 percent of their taxable income annually.

Because the entities might not have enough cash on hand, section 305 allows the total amount of some part-stock, part-cash distributions to qualify as a section 301 distribution if an entity's shareholders can make a stock or cash distribution election.

In 2017 the IRS formalized its historic (pre-Great Recession) requirements for stock-cash distribution letter rulings in Rev. Proc. 2017-45 by allowing publicly offered REITs and RICs to give shareholders the choice of receiving a distribution in either cash or stock, as long as the entity’s distribution is at least 20 percent cash.

If the entity satisfies the requirements in the revenue procedure, the IRS will treat the stock as a section 301 distribution of property, and the value of the stock that a shareholder receives in lieu of cash will be treated as equal to the amount of cash for which the stock is substituted.

During the recession, the IRS issued a series of revenue procedures to address liquidity issues at that time, with the last one (Rev. Proc. 2010-12, 2010-3 IRB 302) extending the effective date through 2011. The procedures allowed part-stock, part-cash distributions if the distribution was at least 10 percent cash.

Other Considerations

REITs are generally thought of as companies that own and manage several income-producing real estate properties such as shopping malls or office buildings, but they can also include healthcare facilities, data centers, cell towers, and other businesses.

Congress created REITs and gave them preferential tax treatment like mutual funds because it wanted the average investor to be able to own an interest in large-scale commercial real estate as a means of portfolio diversification.

Practitioners had anticipated that the IRS would pull from the 2008 financial crisis playbook as a starting point for REIT relief, but they also noted that today’s situation isn’t as straightforward, potentially requiring other, but not necessarily novel, solutions.

Further relief that might be warranted includes treatment of prohibited transactions and application of the reasonable cause rules.

For example, under previous extreme economic conditions, the IRS recognized that the REITs at issue had limited options for obtaining the cash necessary to meet their operating needs and issued two letter rulings (LTR 200945025 and LTR 200953018) that concluded that the sales didn’t give rise to a prohibited transaction.

Several REIT rules under sections 856 and 857 say that if an entity’s failure to satisfy specific requirements is “due to reasonable cause and not due to willful neglect” and it satisfies any other specified requirements, the failure won’t jeopardize its REIT status.

One practitioner had suggested that the IRS consider offering more generous use of REIT relief provisions, such as those reasonable cause rules, as it did in the aftermath of the 2005 hurricanes, to situations in which an entity might otherwise lose REIT status because of circumstances beyond its control.

Broader Relief Requested

In a March 24 letter to Treasury, attorneys from Dechert LLP requested that a modified 10 percent cash distribution safe harbor apply for all RICs.

The firm also recommended that the relief “remain effective for all distributions paid on or before the date which is two years from the termination of the National Emergency,” compared with Rev. Proc. 2020-19, which extends the relief through the end of the year.

According to the firm, the guidance issued during the 2008 financial crisis “was of extreme assistance to many RICs at the time,” but it was unclear why the relief was limited to “RICs whose shares were exchange-traded on an established U.S. securities market.”

Dechert also noted that the 2017 revenue procedure isn’t restricted “to only exchange-traded RICs but is restricted to ‘publicly-offered’ RICs” as defined under section 67(c)(2)(B).

“The COVID-19 crisis has put severe stress on the financial markets, which is severely impacting investment funds and their portfolio companies,” the letter said. The firm argued that all RICs — not just those that are publicly offered — have been affected, many of which “are anticipating reducing and/or delaying their dividends.”

Dechert thus recommended that “the guidance not be limited to publicly-offered RICs but instead be extended to cover all RICs qualified under section 851(a).”

The firm said RICs that “are not publicly-offered are excluded from the 2017 guidance [but] . . . there is no discernable tax policy or other policy reason for this exclusion, and we recommend that the exclusion be dropped.”

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