Real estate investment trusts, or REITs, are famously required to pay out most of their earnings as dividends in exchange for being treated as pass-through businesses by the IRS. The short version is that when a REIT calculates its taxable income for a given year, it must have paid out at least 90% of it as dividends.
However, there's quite a bit more to the story. Most REITs don't pay out more than 90% of what they actually earn, but also pay out far more than 100% of their taxable income. Confused? In this article, we'll make some sense out of the REIT distribution requirements and what they mean in real-world REIT investing.
REITs have a high payout requirement
There are a few different criteria a company needs to meet in order to gain REIT status and therefore avoid corporate taxes. Just to name a few, REITs are required to invest at least 75% of their assets in real estate investments, must derive at least 75% of their income from real estate sources, and must have at least 100 shareholders. All of these rules apply to any publicly traded REIT, private REIT, or public non-traded REIT. And they apply to equity REIT and mortgage REIT companies equally.
However, the best-known requirement by far has to do with distributions. REITs are required to distribute a minimum of 90% of their taxable income to shareholders. After all, this is why REITs typically offer a higher dividend yield than the average S&P 500 stock. If they do this, they are considered pass-through entities in the eyes of the IRS and aren't subject to corporate income tax on their profits. And this also means that REIT dividends are typically treated as ordinary income for shareholders, not as qualified dividends, which is a special tax treatment most stock dividends are given.
The distribution requirement isn't quite as strict as it sounds
Now, a 90% taxable income distribution requirement might sound like a REIT is required to distribute substantially all of its profits. But that's not really the case.
The reason is that taxable income isn't a very accurate reflection of how much money a REIT is actually earning. I won't get too deep into the tax benefits of real estate investing, but a real estate investor is entitled to claim a big tax deduction -- known as depreciation -- every year. This is reflected as a business expense on a REIT's income statement, but it doesn't actually cost the company anything. To make a long story short, depreciation can make a REIT's profits look much smaller than they actually are.
A far better metric for REIT investors to gauge profitability is funds from operations, or FFO. This metric adds the depreciation "expense" back in and makes a few other adjustments to better reflect profitability.
If you're asking yourself how much of a difference the depreciation tax deduction can make for an investor, the answer is "a lot." As an example, large net-lease retail REIT Realty Income (NYSE: O) produced $1.14 per share in net income in the 2020 tax year. But its FFO, the more accurate measure of its profitability, was $3.39 – nearly three times as much as the traditional net income calculation suggests.
In practice, many REITs don't pay out anything close to 90% of what they actually earn, as we'll see in the next section. In fact, it's not uncommon for a highly profitable REIT to show a loss for taxable income purposes and therefore have no distribution requirement whatsoever. In real-world situations, most REITs pay out more than 100% of their taxable income but pay out significantly less than 90% of their FFO, leaving more profits than you might expect to reinvest in the business.
Real-world example of REIT distribution requirements
Since I mentioned Realty Income in the last section, let's use that as an example of how much of their profits REITs actually pay out in the real world. In 2020, Realty Income generated net income of $1.14 per share, as I said in the last section. As of this writing, the stock's annual dividend is $2.814 per share. At first glance, it looks like Realty Income pays out a staggering 247% of its profits. And from the IRS's perspective, it does.
However, Realty Income's FFO was $3.39 in 2020, so the reality is somewhat different. Based on this figure, which represents the company's actual profits, Realty Income pays out about 83% of its profits as dividends to shareholders. So, although the company paid out far more than 90% of its taxable income to shareholders, it paid out a significantly lower percentage of its real earnings.
The Millionacres bottom line
The bottom line is that REITs are required to pay out at least 90% of their taxable income, but a REIT's taxable income almost never tells the full story of how much money the REIT actually earned. When you look at funds from operations (FFO), which is a much more accurate picture of REIT "earnings," there is no minimum distribution requirement.