"It's like dj vu all over again," Yogi Berra reputedly said. We all hoped that we would only have to live through one Great Recession, but here we go again. This memorandum briefly identifies some of the tax issues REITs should have on their radar screens in the current COVID-19 crisis. It does not go into detail on each issue, but is designed to help REITs spot tax issues on the horizon. The list begins with less severe issues and progresses to more distressed situations.

1. Income Test Projections

A REIT must have at least 95% of its gross income derived from certain qualifying income sources and at least 75% of its gross income derived from real estate-related sources. The two REIT gross income tests are measured on an annual basis, though REITs typically track compliance with those income tests on a quarterly basis. REITs should consider forecasting any significant changes in their mix of qualifying and non-qualifying income for the balance of 2020 to ensure that any gross income test problems are identified before it is too late in the year to correct them. In many cases, the rate of decrease of nonqualifying income will be the same (or greater) as the rate of decrease of qualifying income, but that may not always be true. One example is a joint venture, where the fees the REIT receives from the JV do not decrease, but there is a decrease in the REIT's share of the JV's revenues.

2. Asset Test Valuations

The values that REITs use for asset testing purposes have generally never tracked the REITs' market capitalization or analysts' estimates of net asset values. Many REITs have been comfortable using their GAAP balance sheets as the appropriate valuations for asset testing purposes. GAAP balances were viewed as conservative because REITs believed their assets were actually worth more than the GAAP balances.

The world looks different now. Many REIT stocks are trading at 52-week lows, and at significant discounts to their valuations from as recently as February 2020. Each REIT must make its own judgment about how to value its assets, and may well take different approaches depending on their circumstances in this new environment. The REIT rules simply say that value means "fair value as determined in good faith by the trustees." Having the REIT's board of directors review the asset tests each quarter and approve the values included in those tests is best practice for ensuring that the asset values will be respected for tax purposes.

While the REIT asset test rules provide that mere changes in values will not cause a REIT to fail to meet the asset tests, REITs should be particularly careful regarding the acquisition of certain assets (including pursuant to contractual purchase obligations and OP unit redemptions), as such acquisitions may cause the REIT to lose the benefit of such grandfathered asset test qualification.

3. Lease Workouts

Many equity REITs will not be able to avoid tenants asking for relief on their rental payments. That relief could be in the form of deferrals of payments, reductions in payments, or deferrals that end up being reductions. One issue with lease amendments is to ensure that the amendments do not convert qualifying income to non-qualifying income.

One restriction in the REIT rules is receiving rent that is based, in whole or in part, on the net income or profits of the tenant, such as if the rent is based on a formula of the tenant's EBITDAR earnings before interest, taxes, depreciation, amortization and rent. Another REIT restriction is taking a 10% or greater ownership interest in the tenant. Advancing money to the tenant in the form of a loan will need to be tested under the REIT asset and income tests, although there are some helpful rules in the context of the 10% value asset test.

4. Satisfying Distribution Requirements

The tradeoff for allowing REITs to deduct their dividends is the requirement that they generally distribute annually at least 90% of their net taxable income, other than net capital gains. REITs should distribute 100% of their net taxable income, including net capital gains, to avoid paying any entity-level corporate income tax. In difficult financial times, when REITs are trying to conserve cash, that distribution requirement can be more burdensome than the corporate income tax. If a REIT finds itself with more net taxable income than cash available for distribution in 2020, several options are discussed below.

a. Reduce Taxable Income

A REIT may reduce its net taxable income in several ways, some of which have been made more favorable for taxpayers by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), signed by the President on March 27, 2020. A REIT can carry forward post-2017 net operating losses (NOLs) indefinitely, to reduce up to 100% of the REIT's net taxable income in 2018 through 2020 and up to 80% of the REIT's net taxable income in 2021 and later. A REIT can carry forward pre-2018 NOLs for up to 20 years, to reduce up to 100% of the REIT's net taxable income. While REITs historically have not focused on NOLs, as they pay out their cash flow in a manner that reduces their net taxable income to zero and in a manner that is often dictated by a market-based yield, some REITs do carry NOLs.

Under the CARES Act, qualified improvement property placed in service in 2018 and later is eligible for bonus depreciation for a REIT that has not elected out of the Section 163(j) business interest deduction limitation. As a result, qualified improvement property placed in service in 2018 through 2022 may be fully deducted for federal income tax purposes. For a REIT that has elected out of the Section 163(j) business interest deduction limitation as a real property trade or business, it may nevertheless claim bonus depreciation on personal property and depreciate its qualified improvement property placed in service in 2018 and later over a shorter 20-year recovery period (instead of 40 years before the CARES Act). Although most states do not conform to bonus depreciation, which has caused many REITs to historically elect not to claim bonus depreciation, it may be worthwhile for some REITs to start claiming bonus depreciation in 2020 and later in order to manage their dividend distributions, even if the REITs have to pay some state income taxes.

A REIT may increase its deductions by conducting cost segregation studies to increase its depreciation deductions and tangible property regulation studies to increase its repair deductions, to the extent that it has not already done so for some properties. Although the studies provide only temporary timing benefits by accelerating tax deductions, which must be weighed against the permanent cost of undertaking the studies, the accelerated tax deductions can increase the REIT's cash liquidity on an immediate basis. The increased deductions may provide a helpful cushion in the REIT's income modeling in case the REIT has unanticipated additional taxable income, such as cancellation of debt income from debt relief.

New York has decoupled from some features of the CARES Act for purposes of various New York State and New York City income taxes, which may cause a REIT with zero federal taxable income to still have taxable income subject to the New York State corporation franchise tax and New York City business corporation tax. Other states may decouple from particular aspects of the CARES Act once their legislatures are back in session.

b. Delay Dividends

Dividend distributions do not have to be made quarterly, and can be delayed to January of the following year and still count as distributed in the current year (provided that they are paid to the shareholders of record in October, November or (most typically) December of the current taxable year). Dividends can be made even later in the following year, though a non-deductible 4% excise tax may be triggered in certain circumstances.

c. Partial Stock Dividends

Publicly-traded REITs can avail themselves of the existing IRS guidance on partial stock dividends dividends where the shareholders elect to receive either stock or cash, subject to a 20% minimum amount of the total dividends to be paid in cash. If too many shareholders elect to receive cash, the 20% minimum cash distribution is generally allocated on a pro rata basis. Nareit has asked the Treasury to reduce the cash limitation percentage to 10% with respect to distributions in 2020 and 2021, similar to what the Treasury did during the 2008-2009 recession. The stock dividends are taxable income to shareholders, who may have to use other sources of cash to pay their federal, state, and local income taxes on their dividend income.

The effective result of a stock dividend is that the REIT is issuing new shares at a price that may be relatively low, albeit generally on a pro rata basis. By increasing its outstanding number of shares, the REIT may dilute its earnings per share and reduce its stock price.

REITs that do not already have distribution reinvestment programs (DRIPs) may also wish to adopt such programs, pursuant to which cash otherwise paid as a dividend is reinvested in additional shares of the REIT by electing shareholders, recognizing the stock price issue noted above.

d. Consent Dividends

Although not practical for publicly-traded REITs or widely-held, non-traded REITs, private REITs can use the consent dividend with respect to its common shareholders, where the shareholders agree to be treated as receiving a taxable dividend and reinvesting the dividend back into the REIT, in each case, for U.S. federal income tax purposes.

e. Dividend Limitation in Rescue Funds under the CARES Act

The CARES Act includes several new funding programs for middle market and investment grade businesses. Unfortunately for REITs, one requirement for certain loans in the $454 billion Treasury lending program is that the borrower agree not to "pay dividends or make other capital distributions with respect to the common stock" of the borrower until the date that is 12 months after the loan is repaid. Nareit believes the dividend limitation in the CARES Act was an oversight with respect to REITs, and is optimistic that it will be addressed in regulatory guidance or future technical correction legislation.

5. Adjustments or Amendments to 2019 Tax Returns

Private REITs can consider making adjustments or amendments to their 2019 tax returns to lower 2019 taxable income for the REITs' shareholders and reduce the income tax that they generally have to pay around July 15, 2020. For example, the IRS issued guidance allowing REITs and their lower-tier partnerships to make elections (or revoke prior elections) under Section 163(j) for real property trades or businesses and to increase the Section 163(j) business interest deduction to 50% of EBITDA in 2019 (instead of 30%). Another example is the election, under Section 165(i), to deduct losses attributable to a federally declared disaster (such as the COVID-19 crisis) in the taxable year before the disaster occurred. The Section 165(i) election is one of the few ways that a REIT can effectively carry back tax items to the prior year, because a REIT cannot carry back NOLs or capital losses.

The above adjustments are less practical for publicly-traded REITs or widely-held, non-traded REITs because of the complexities of amending Forms 1099-DIV issued in January 2020 to a large number of shareholders.

6. Payroll Tax Deferral and Employee Retention Tax Credits

The CARES Act increases cash liquidity for REITs and other employers by allowing them to defer and pay in installments the employer portion of the Social Security tax (currently 6.2% of up to $137,700 of wages per employee annually) due from March 27, 2020 through December 31, 2020. The first half of such deferred taxes would be due on December 31, 2021, and the second half on December 31, 2022. Medicare taxes and the employee portion of the Social Security tax remain due in the same manner as before the CARES Act.

In addition, REITs and other businesses (i) whose operations were fully or partially suspended due to governmental orders related to COVID-19, or (ii) which had a year-on-year gross receipts decrease of at least 50% generally in one or more quarters in 2020, may receive a refundable credit against payroll taxes equal to 50% of qualified employee wages paid from March 13, 2020, to December 31, 2020, with up to $5,000 of tax credits per employee. For a business with more than 100 full-time employees, only wages paid to employees not providing services, due to either of the reasons above, qualify for the tax credit. Complex aggregation rules apply in determining whether a business qualifies for this employee retention tax credit and its number of employees.

Other refundable payroll tax credits are available for REITs and other businesses that provide certain types of paid sick leave and paid family and medical leave, as required through the end of 2020 by the Families First Coronavirus Response Act generally for employers with fewer than 500 employees.

Some REITs, particularly hotel REITs and healthcare REITs, may be eligible to receive a Paycheck Protection Program (PPP) loan through a program administered by the Small Business Administration. A REIT that receives a PPP loan is not eligible for the employee retention tax credit, though it may claim the paid sick leave and paid family and medical leave tax credits. The REIT ceases to be eligible for future payroll tax deferral if the PPP loan is forgiven, but its previously deferred payroll taxes remain deferred to 2021 and 2022. REITs that are eligible to receive a PPP loan will have to determine whether it is more advantageous to take the PPP loan, which may be forgiven, or to claim the employee retention tax credit.

7. Savings Provisions

During turbulent times, when REITs find themselves engaging in unusual transactions with uncertain tax consequences, it is important to keep in mind the REIT "savings provisions" that allow a REIT to save its REIT status by paying a penalty tax.

Other than for de minimis asset test failure, the REIT savings provisions require the REIT to act with "reasonable cause and not due to willful neglect." The regulations define that standard as exercising ordinary business care and prudence in attempting to satisfy the REIT requirements, and specifically provide that reasonable reliance on a reasoned, written opinion from a tax advisor (including in-house counsel) meets that standard. Accordingly, if a REIT is unsure about the tax consequences of a particular transaction, it may prefer to seek a contemporaneous written opinion from a tax advisor to establish reasonable cause.

One example of an extraordinary transaction is the receipt of grant income by a REIT. The IRS has the authority to determine whether income can be disregarded or treated as qualifying income under the REIT gross income tests, and has done so on several occasions, but there usually is not enough time to obtain a private letter ruling, and relying on a tax advisor's written opinion may be the only practical option.

8. Deadlines for 1031 Transactions and Opportunity Fund Investments

The IRS has postponed certain deadlines in Section 1031 transactions and for investments in qualified opportunity funds to help REITs and other taxpayers defer their gains during the COVID-19 crisis. Specifically, if the end of the 45-day identification period or the end of the 180-day exchange period of a Section 1031 exchange falls between April 1, 2020 and July 14, 2020, those deadlines are extended to July 15, 2020. Similar extensions apply to the 45-day and 180-day periods in "reverse" Section 1031 exchanges and to the 180-day periods for making investments in qualified opportunity funds. It is unclear whether taxpayers may use certain prior IRS guidance that would extend all like-kind exchange deadlines on or after March 13, 2020 (i.e., the date of the federally declared disaster) for up to 120 days, which may be confirmed by the IRS in a FAQ or other future guidance. The extended deadlines may help REITs and their counterparties that are experiencing difficulties in conducting due diligence, obtaining financing and title insurance, or engaging in other acquisition or disposition activities.

9. Acquisition of Distressed Assets

When markets are chaotic, there are, by definition, opportunities. Several REIT-related restrictions apply to opportunistic REITs.

a. Distressed Mortgage Loans

The acquisition of distressed mortgage loans, and the "significant modification" of those loans, requires special attention to the REIT asset and income tests. When debt is significantly modified, the tax rules treat the old loan as being exchanged for a new loan. The modification may result in taxable income to the debt holder, and convert a mortgage loan or other qualifying asset into a non-qualifying asset for the REIT. There are relief provisions in the REIT asset and income tests when a mortgage loan, which was initially fully secured by real property, is significantly modified at a later date.

b. Prohibited Transaction Tax 

The Achilles heel of REITs is the prohibited transaction tax a 100% tax on the gain on sale of property held by the REIT primarily for sale to customers in the ordinary course of the REIT's trade or business, which is a facts-and-circumstances determination. There is a safe harbor for sales meeting certain requirements, including a two-year holding period requirement and, in the case of real property, a requirement to generally hold such property for two years for the production of rental income. The prohibited transaction tax may apply to a REIT that has to sell or otherwise dispose of its assets in a taxable transaction, such as in a foreclosure or deed in lieu of foreclosure, although the IRS has privately granted relief to REITs in similar situations. The prohibited transaction tax must also be considered for REITs that intend to acquire distressed mortgage loans and other real estate assets with a plan to sell those assets after a short holding period, although the issue is generally less sensitive for stocks and securities as opposed to equity real estate.

10. Loan Workouts

The last topic is our least favorite, and hopefully not one many REITs will have to confront. A complete discussion of the tax considerations of loan workouts is beyond the scope of this memorandum, but it is important to identify a few ways in which loan workouts can present tax issues for borrower REITs.

Forgiveness of debt generally results in cancellation of debt (COD) income for the borrower. A borrower can recognize COD income when its debt is "significantly modified" (i.e., when the issue price of the new debt is less than the adjusted issue price of the old debt). For example, a REIT may have COD income if it modifies its publicly-traded or quoted bonds at a time when the bonds are valued below par, even if the old and new bonds have the same principal amount. COD income also can arise for a borrower when a related person acquires the borrower's debt or becomes a related person after the debt is acquired.

When a lender forecloses on property, or takes the property by deed in lieu of foreclosure, the tax treatment of the borrower depends on whether the debt is recourse or nonrecourse. Nonrecourse debt generally produces capital gain for the borrower, whereas recourse debt can produce a combination of COD income and capital gain (or loss).

Whether there is debt forgiveness or a property foreclosure, the tax issue for the REIT is how to distribute the income or gain to avoid a corporate-level income tax on that income or gain, when there is no cash generated from the transaction. COD income generally is not required to be distributed under the 90% distribution requirement to maintain REIT qualification, and is disregarded for the REIT gross income tests, although the undistributed COD income is subject to corporate income tax.