The taxability of dividends stems from calculating earnings and profits (E&P), which measures a corporations economic income. Under Secs. 301(c)(1) and 316(a)(2), E&P is neither GAAP earnings nor taxable income; it is simply a measure of a corporations ability to pay dividends from its economic earnings. Specifically, two of the many differences between taxable income and E&P are the inclusion of tax-exempt income and differing depreciation lives. Generally, the calculation works for more traditional corporations (e.g., manufacturers or retailers), because they are using truly depreciating assets in their businesses, while not receiving a current deduction (for taxable income or E&P) for their inventory. On the other hand, real estate corporations are allowed a depreciation deduction (for both taxable income and E&P purposes) for their assets (substantially real estate), which generally appreciate. In other words, real estate corporations receive a current deduction (depreciation) for their inventoryreal estatethat may have a tremendously long operating cycle.

Clearly, neither E&P nor taxable income is a good way to measure a real estate corporations ability to pay dividends; cashflow would be a more appropriate measure. Despite this, the tax law uses E&P to measure a real estate corporations earnings.

Generally, any dividend deemed paid out of E&P is an ordinary dividend taxed at the same rate as net long-term CG. Dividends paid in excess of a corporations current or accumulated E&P are a return of the investors capital (ROC); any remaining dividend is CG. Additionally, as a departure from the standard E&P rules, CGs within a REIT retain their character on subsequent distribution to the shareholder.

Normally, REITs seek to maximize dividend payments to investors and often distribute dividends well in excess of Sec. 857(a)(1)(A)(i)s 90%-of-taxable-income requirements. Often, this is easily achievable, as cashflow can well exceed either taxable income or calculated E&P. The biggest cause for this discrepancy is the difference between depreciation in excess of principal payments on loans. Additionally, because REITs generally do not reduce dividend payments for fear of damaging shareholder value, they often do not do this when the timing differences in depreciation and loan principal payments turn around. Given these dividend yields in excess of taxable income and E&P, REITs often issue dividends that have a mixed tax character

In the example, B (an individual) would pay an effective tax rate of 11.3%. Of course, this would be lower if B had capital losses to offset against the $350 of CG dividends; the effective rate could be as low as 6%. The $250 of ROC dividend is an adjustment that reduces Bs basis to $9,750 ($10,000 $250), which creates a deferral triggered on a sale (or even a permanent deferral, assuming a basis step-up on death).

Functionally, this ROC distribution resembles a nontaxable cashflow representative of the depreciation deduction. In light of the calculation, the REIT shares could be perceived as a surrogate for actual real estate investments, as Congress intended. Additionally, the tax rate on the ordinary and CG portions of the dividend would be reduced below 15% if B were in a lower tax bracket.

The analysis indicates that the best investor in REIT shares is an individual in a high tax bracket who desires a high after-tax cashflow yield. Despite this, some of the largest investors in REIT shares are institutions, especially qualified pension and retirement plans. This does not seem like the best investor class, as such investors cannot take advantage of the favored tax position available to REIT shares. Of course, qualified plans get an extended deferral until the funds are withdrawn by a beneficiary, but all funds are taxed at the highest marginal ordinary income tax rates at that point. Arguably, REIT shares would be a better investment in an individuals taxable account, while high-yield investment-grade corporate bonds would generate better cashflow for a qualified plan, as corporate bonds are subject to ordinary income rates anyway.