A new problem is emerging for cash-strapped income investors.  Dividends may be coming in the form of more stock instead of cash.

The IRS requires REITs and Close End Funds to distribute the vast majority of income to investors each year in the form of capital gains and dividends. However, the IRS has changed the rules in response to the market downturn and is now permitting REITs and Closed End Funds to substitute shares for cash. The problem with this approach is that it has a double negative impact on investors who count on dividends for income.

First, investors count on dividend checks to pay bills and supplement other retirement income.  Getting more shares in the mail instead of cash is not helpful.  To use a common Wall Street metaphor, you can’t eat more shares.

Second, issuing a dividend in the form of more shares is akin to dividing the same birthday cake into 12 pieces instead of 9.  The size of the cake remains the same, however, the pieces get smaller.

To add insult to injury, the dividend is considered taxable even if it comes in the form of shares instead of cash.  When investors go to pay their higher tax bills, here’s a hint – the IRS doesn’t take diluted shares, only cash.

According to the Wall Street Journal, several major closed end funds are taking advantage of the IRS ruling and issuing shares in lieu of cash. Although the IRS ruling came in time to affect the 2008 year-end payouts for REITS, the new rules won’t apply to closed end funds until 2009.  Still, as the article Some Cash Payouts May Disappoint reports,  6 closed end funds limited cash distributions in 2008.

Under the new rules, REITs can pay up to 90% of the dividend in stock leaving only 10% for cash.  According to the WSJ article, REITs Paper Over the CracksSimon Property Group and Vornado Realty Trust are both issuing most of their 2009 dividends in stock.

An ETF with a large holding in Simon is the FTSE NAREIT Retail Index Fund (RTL) which holds over 24% of the fund in the mall operator.  The Vanguard REIT ETF (VNQ) is another large Simon investor.

The iShares Cohen & Steers Realty Majors Index Fund (ICF) is a large holder of Vornado Realty Trust with over 7% of the portfolio in the company.

For more, see Investing in REITs with ETFs.