A special kind of real estate related corporation is under Legislative scrutiny- again. A “real estate investment trust,” or REIT, provides significant benefits under the federal tax code. In Hawaii however, State lawmakers are looking to close tax loopholes.
REITs are related to investing in real estate or loans secured by real estate. Established by Congress in 1960, certain requirements must be met to maintain a REIT. In addition to how it is organized and owned, a REIT must also payout virtually all of its ordinary income as dividends.
Where the tax benefit comes in is when the dividend goes out. The REIT is allowed a tax deduction upon payout- something most corporations don’t get.
In the IRS view, a REIT is a pass through entity- meaning it doesn’t pay tax. Shareholders are supposed to pay tax on the dividends. However, most dividend recipients reside outside of Hawaii, so they are not paying Hawaii tax on the dividend income. That’s where we begin to see the conflict come to light.
One side argues for encouraging investment dollars. They are generally opposed to taxing people if their only connection with a state is receiving a corporate dividend from a company headquartered within the state. There is concern that investors may leave Hawaii REITs if this benefit goes away. Other states allow similar REIT structures to foster investment.
The other side claims this creates a scenario where not all taxpayers are treated the same. Hawaii collects taxes from out-of-state shareholders in S corporations, so why would it not view REIT shareholders in the same way?
Also a question is what qualifies as a REIT. A mainland telecom received an IRS ruling encompassing all of its runs of copper and fiber-optic lines as qualifying real estate, cutting an estimated $100 million of its Federal tax bill. Other companies with unusually distributed real estate, such as billboard properties, computer data storage facilities, even private prisons, were cleared by the IRS as REITs.
In Hawaii, REITs own some of the largest hotels and shopping centers, including Alexander & Baldwin, “Hawaii’s largest owner of grocery/drug-anchored retail centers.”
How operations benefit from a REIT
A company puts its real estate holdings into a REIT, and an operating company rents 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, including virtually no Federal tax.
How big are REITs in Hawaii?
According to the website HI Tax Fairness, “REITs own approximately $17 billion worth of Hawaii real estate and earn about $1 billion in profits every year. Hawaii loses an estimated $60 million in potential tax revenue every year due to the REITs tax loophole.”
The pros and cons of REITs are before the Hawaii State Legislature now. House bill 475, disallowing dividends paid as a tax deduction for real estate investment trusts, was passed on March 1, and has moved on to the Senate. It’s not the first time REITs have caught the attention of lawmakers, and if not passed, it surely won’t be the last.