Real Estate Investment Trust: A new kind of tax shelter

By Tom Yamachika – This week we will talk about a special kind of corporation called a “real estate investment trust,” or REIT. Some people have called it the modern-day tax shelter, as it provides significant benefits under the federal tax code.

REITs are investment vehicles that were established by Congress in 1960. To maintain its status, a REIT must meet certain requirements as to its ownership, organization, and the nature of its income and assets. A REIT’s activities are generally limited to investing in real estate or loans secured by real estate and related activities. It must pay out substantially all of its ordinary income as dividends. The tax benefit for a REIT is that it is allowed a deduction for dividends paid out, which most corporations don’t get. Because of that rule, for federal income tax purposes, a REIT is generally treated as a passthrough entity, which means that the REIT doesn’t pay tax but its shareholders are supposed to pay tax on the dividends they receive from the REIT.

REITs own some major pieces of real estate in Hawaii. There are about 20 publicly held REITs that collectively own about $6 billion in Hawaii commercial real estate. They do pay taxes, including our General Excise Tax (GET), because rent income that the REITs receive is taxable for GET purposes. They also pay real property taxes to the counties in which they own property.

For corporate net income tax, however, it’s another story. The REITs in Hawaii pay little or no tax under the net income tax system because of the deduction allowed for dividends paid, while the majority of the REITs’ owners who receive the dividend income are outside of Hawaii and don’t pay Hawaii tax either.

Why? States generally don’t tax people if their only connection with a state is receiving a corporate dividend from a company headquartered within the state. The states would rather have the investment dollars flow into the state than try to tax them and scare off the investors. On the other hand, our state does try to get its tax share from out-of-state shareholders in S corporations; so it might not be illogical for our state to tax REIT shareholders the same way.

What qualifies as real estate for REIT purposes is an issue that recently has been in the news. Windstream Holdings, an Arkansas-based telecommunications company, in July received a private letter ruling from the IRS that allowed most of its copper and fiber-optic lines as qualifying real estate, which could enable it to cut more than $100 million a year off its federal tax bill. REITs have also been used by computer-data storage companies, billboard owners, and private prisons.

In one closely watched situation, the IRS in June cleared document-storage and shredding company Iron Mountain Inc. to restructure as a REIT. Of course, operating companies don’t, by themselves, qualify as REITs. What they do is to put their real estate holdings into a REIT and have the operating company rent those assets from their REIT. The taxable operating company then gets a deduction for the rent; the REIT recognizes the rent as income but pays substantially less tax on that income.

Is all of this a good deal? Is it a tax dodge? Is this kind of tax structuring tolerable because other states are letting REITs do this? Or is it necessary for us to change the rules that apply to REITs, as one other state (New Hampshire) has? These, and other thorny questions, are going to be considered by our lawmakers in the coming months.

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