Two measures (SB 118 and HB 82) proposed in Hawaii in January would have eliminated the dividends paid deduction (DPD) for real estate investment trusts. The measures have been deferred pending further study. Supporters of the bills contend that dividends paid by REITs should be taxed before distribution, but opponents claim doing so would have a chilling effect on the use of REITs in Hawaii.
A REIT is a company that uses the pooled capital of many investors to purchase and operate income-producing property or to finance real estate. REITs can either be private or offered as a publicly traded security. Individual investors purchase a unit of the investment trust. Each unit represents a proportionate fraction of ownership in each of the underlying properties in the REIT. REITs are popular for small investors because REITs allow them to invest in real estate without needing to have the necessary capital for direct ownership of those same properties.
REITs may be created for a single development project or they may be set up for a specific number of years. In either case, when the project is over or the requisite number of years has passed, the REIT is liquidated and proceeds are distributed to shareholders. If a REIT is publicly traded, it may be either closed-ended, meaning it can issue shares to the public just once unless approval is obtained from current shareholders, or open-ended, meaning it may issue shares and redeem shares at fair market value at any time.
For federal tax purposes, REITs are taxed as corporations, which means that they are taxed first at the entity level and then at the shareholder level. However, REITs function as hybrid entities in that they are taxed as passthrough entities as long as they comply with the requirements to maintain their REIT status. To enable the trusts to avoid corporate-level taxation, REITs are permitted to deduct dividends paid to shareholders from their corporate taxable income. And because REITs are required by law to distribute at least 90 percent of their taxable income to their shareholders each year, with most REITs distributing 100 percent of their taxable income, this means that REITs effectively avoid federal income tax. REITs will, however, be subject to corporate-level tax on what is left after their annual distributions. That is, if a REIT chooses to distribute 90 percent of its taxable income, it will become subject to corporate-level tax only on the remaining 10 percent.
REIT dividend payments are taxable to the shareholder as ordinary income. Under IRC section 243(d)(3), dividends issued by a REIT to shareholders are not considered a dividend for federal income tax purposes. That means shareholders are not permitted to take a dividends-received deduction for dividends received from a REIT. If, however, the dividends qualify as capital gains, they are taxed at the capital gains rate. If a dividend qualifies as a capital gain dividend, it is long-term capital gain to the shareholder regardless of whether the sale of that shareholder's unit shares would result in long-term capital gain or loss.
Because many states conform to the federal tax code, REITs are generally afforded similar treatment at the state level. However, state conformity to the Internal Revenue Code is anything but simple, particularly regarding the tax treatment of REITs. For those states that impose an income tax, most begin the calculation of state taxable income with federal taxable income, or they incorporate federal taxable income in some manner in the state tax code. Also, most states follow the federal treatment of REITs by allowing for a DPD. In some cases that is because the definition of state taxable income is federal taxable income after the DPD or, if the definition of state taxable income is federal taxable income before the DPD, the state will provide for a state-level DPD.
However, some states deviate from the federal rules, typically by limiting or modifying the DPD. For example, New Hampshire imposes an entity-level tax on REITs, without subtracting the dividends paid. It is also important to note that even if the DPD is allowed, some states require that the REIT and any qualified REIT subsidiaries (QRS) file income tax returns. There also are states, such as Mississippi, where the DPD is allowed only if the REIT is publicly traded.
Let’s turn back to Hawaii’s predicament. Hawaii is not the first state to consider how to subject REITs to corporate income tax and will likely not be the last. But as Hawaii discovered, data on the economic impact of REITs (particularly in terms of state tax revenue) is difficult to come by. The reason is that it is often unclear how much tax revenue should be going to each state. Because of the DPD, most of a REIT’s income is not taxed at the state level. What income is passed might also not be subject to tax at the state level if the corporate or individual shareholder is located in a state that does not impose any income tax or allows for a dividends received eduction from a REIT.
This has created the perception that REITs are the next great tax shelter, but the perception may not be reality. NAREIT reported that 20 REITs have invested approximately $6 billion in commercial real estate in Hawaii. Those 20 REITs paid property and excise taxes, and Hawaii shareholders of those REITs paid income tax on REIT dividends, all beneficial the state.
Still, it’s a difficult topic, there are a lot of subtopics, and there is a lack of solid data. States will continue to explore the taxation of REITs and the options available to them. Perhaps the transfer tax will be the subject of a blog post soon.