90% Distribution Rule

What is the 90% Distribution Rule?

The 90% Distribution Rule is a fundamental requirement for any entity seeking to qualify as a Real Estate Investment Trust (REIT) under U.S. tax law. To maintain its special tax status, a REIT must distribute at least 90% of its taxable income to its shareholders each year. This rule allows REITs to avoid paying corporate income tax, effectively operating as a pass-through entity. Instead, the income is taxed at the shareholder level, preventing double taxation.

How It Works

The rule ensures that the vast majority of a REIT's earnings are passed directly to investors. This mechanism makes REITs attractive for income-focused investors, as they typically offer higher dividend yields compared to many other equity investments. The taxable income for this calculation includes rental income, interest income, and gains from property sales, after deducting operating expenses but before deducting federal income taxes.

Key Components

• Taxable Income: This refers to the REIT's income as calculated for tax purposes, not necessarily its accounting net income. It includes rental income, property sale gains, and other earnings.
• Distributions: These are the payments made to shareholders, typically in the form of dividends. These distributions are generally taxed as ordinary income for the shareholder.
• Tax-Advantaged Status: By adhering to the rule, REITs avoid corporate tax, allowing more capital to flow to investors or be reinvested in properties.

Implications for Investors

• High Dividend Yields: The rule naturally leads to REITs paying out a significant portion of their earnings as dividends, making them attractive for income-seeking investors.
• Taxation: While REITs avoid corporate tax, shareholders are responsible for paying taxes on the distributions received, often at ordinary income tax rates, which can be higher than qualified dividend rates.
• Growth vs. Income: Due to the high distribution requirement, REITs retain less capital for internal growth compared to traditional corporations, often relying on debt or equity issuance for expansion.

Real-World Example

Consider a publicly traded REIT, 'Prime Properties Inc.', which reports a taxable income of $100 million for the fiscal year 2023. To comply with the 90% Distribution Rule, Prime Properties Inc. must distribute at least $90 million (90% of $100 million) to its shareholders in the form of dividends. If the REIT only distributed $85 million, it would lose its REIT status and be subject to corporate income tax on its entire taxable income, significantly impacting its profitability and investor returns. By distributing the required $90 million, Prime Properties Inc. avoids corporate tax, and its shareholders receive substantial dividend income, which they then report on their individual tax returns.