Stock Dividends Issued by REITs Instead of Cash Dividends

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People who own shares in Real Estate Investment Trusts (REIT) typically want to receive high cash dividends, not stock dividends.

Thanks to an IRS ruling issued in December 2008, REITs now have the ability to choose to pay some dividends in stock instead of cash.

This certainly goes against the spirit of the original REIT law enacted in 1960, which requires Real Estate Investment Trusts to distribute at least 90% of their income to shareholders in return for not having to pay income taxes on that money.

This means, therefore, they're being allowed to keep cash without paying taxes on it. That's nice work if you can get it -- nobody else in the U.S. except people receiving needs-based assistance (welfare) gets that kind of tax break.

However, the original assumption is that REITs would be able to raise enough funds from the capital markets to stay in business. In normal times, they do that. However, 2008 and 2009 were not normal times.

The Financial Crisis Have Severely Hurt Real Estate Investment Trusts

This ruling is obviously in response to the financial crisis.

More specifically, it's because REITs also borrowed too much money during the real estate boom years, and they're facing the need to pay back mortgages and other financing they simply assumed they could easily refinance -- and, thanks to the credit crunch of 2008-2009, could not.

Now, for tax years ending on or before December 2009, Real Estate Investment Trusts can choose to pay as low as 10% of the distribution in cash, and the rest in shares of stock.

This is a dramatic reduction in dividends. Technically, shares of stock are a dividend, but they are an illusion. Because all shareholders receive the same rate of increase, everybody's percentage ownership interest in the company remains unchanged.

In practical terms, therefore, stock dividends have the same effect as a stock split. The total pie is just cut into more --and therefore proportionately smaller -- pieces. It's not any larger than it was.

However, there's a different -- and galling -- tax consequence. The IRS still considers stock dividends to be dividends. Therefore, even though they're not paid in the form of cash, you must pay taxes (in the form of cash - the IRA doesn't accept shares of stock from us) on those stock dividends.

Stock Dividends Do Have Other Differences From Stock Splits

In a stock split, your original cost basis is not changed -- it's simply spread over more shares of stock.

However, with stock dividends, the cost basis of the new shares is whatever the company ddetermines them to be when it declares the stock dividends.

Thus, if you bought 100 shares of Ajax Realty for $50 per share, your cost basis is $5,000.

If in 2009 Ajaz declares a stock dividend of $5 per share, and the share price is now $125 you'll get 4 new shares.

100 X $5 = $500

$500 / $125 = 4

Those 4 new shares you own will have a cost basis of $125 per share or $500 total.

This would make a difference to you in capital gains taxes if you ever sell your shares of Ajax Realty.

Normally, my advice is never sell so long as your investments continue to send you checks. But now many REITs are now dramatically reducing those checks.

A high dividend rate is why most of them bought shares of REITs in the first place, so this goes directly counter to the interests of REIT shareholders.

What is the Future for REITs?

Therefore, you must make a hard decision regarding these REITs.

They are undergoing hard economic times. That's why they are responding by hoarding cash. The cash they fail to pay out to investors may be the cash that keeps them in business until their profits pick up in a year or two.

Of course, you could also argue that REITs that borrowed too much during the real estate boom demonstrated financial irresponsibility. But it's also true that if they hadn't done so, and there was no credit bust, their net profits would have been behind the companies that did borrow to make profitable acquisitions.

Responsible use of leverage is always an uncomfortable compromise between predicting whether the future will be a boom or a bust. And it's easy to be a Monday morning quarterback.

If you are investing for the future -- that is, you have not retired yet and therefore don't need the dividends to live on -- it's probably best to just hang on.

You could sell your REITs and buy another income-producing investment, but unless you do so within a tax-sheltered retirement account you'll incur capital gains taxes.

And later on, when REITs are paying dividends again, their stock prices will be higher, so they'll cost you more.

If you need your dividends to pay your bills, consider selling the REITs and buying other income producing investments.

It's Now Almost 2011

The economy has not recovered much from the viewpoint of many unemployed people, but the stock market is higher and REITs are again paying cash dividends. They have survived, and their stock prices have gone up a lot.

And many Real Estate Investment Trusts were able to raise needed capital from the financial markets, giving them a big advantage over private real estate investment companies.

Some of the REITs that paid part of their dividends in the form of stock are: Vornado Realty Trust, Simon Property Group, Sunstone Hotel Investors Inc, AvalonBay Communities, DiamondRock Hospitality, Northstar Realty Finance, Developers Diversified Realty, CBL & Associates Properties, Lexington Realty Trust, One Liberty Properties, and Aimco.

Next: Potlatch Corporation

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