From one pocket to the other: the abuse of real estate investment trusts deductions.

AuthorStonecipher, Jennifer
  1. INTRODUCTION

    Many large, multi-state retailers and banks have been acting as their own landlord by paying rent to themselves. Sophisticated corporate tax strategists have employed a method of avoiding state taxes by using a real estate investment trust (REIT) to "own" its real estate. The retailer or bank then pays rent to the REIT, which then turns the money over to a holding company. The rent money ends up back in the hands of the corporate parent, without being subject to state income tax along the way.

    Although this tax loophole has been closed by the federal government, the strategy is still being used to avoid taxes in several states. As states begin to take notice of corporations that avoid millions of dollars in taxes, some have employed various methods of recovering the tax funds and have taken steps to prevent corporations from avoiding taxes in the future. However, not all states have enacted effective means of closing this loophole. This summary analyzes the method of using "captive REITs" to avoid state tax liability, outlines the development of REITs, describes states' efforts in recovering and preventing the use of REIT deductions, and advocates closing the loophole through legislation.

  2. LEGAL BACKGROUND

    To understand the significance of state tax loopholes with regards to captive REITs and the importance of closing these loopholes, it is first necessary to understand the role that REITs play in the economy and the ways in which corporations utilize REITs to avoid state tax liability. This section will first discuss REITs generally, including the statutory requirements on the structure and operation of REITs. Next, this section will describe the history and development of the REIT. Finally, this section will explore the techniques used by captive REITs to avoid state tax liability.

    1. REITs Generally

      A REIT is a type of organization governed by the Internal Revenue Code (IRC). (1) "A REIT is a corporation, trust, or association, that operates like a mutual fund, except that REITs own real estate and mortgages, as opposed to stocks, bonds, and other securities." (2) The REIT allows investors to pool their resources to invest in diversified real estate ventures. (3) Since many REIT shares are traded on the major security exchanges, REITs allow investors to invest in real estate through easily transferable shares. (4)

      In order to qualify for tax benefits, the IRC requires that a REIT must meet specific structural requirements and pass several tests. First, the IRC requires that at least one trustee or director manage the REIT. (5) Freely transferable shares must evidence beneficial ownership of the REIT. (6) The REIT must be taxable as a domestic corporation and cannot be a financial institution or an insurance company. (7) Finally, at least one hundred shareholders must hold the beneficial ownership of the REIT for at least 335 days out of a twelve month period. (8)

      In addition to the structural requirements, REITs must comply with several tests relating to the sources of the REIT's income, (9) the nature of the REIT's assets, (10) and the method of distributing the REIT's dividends. (11) If a REIT meets the requirements and can comply with the tests, the trust may elect REIT status. (12)

      REITs are subject to numerous requirements, but, if it meets the statutory requirements, a REIT qualifies for favorable tax treatment. In order to avoid double and triple taxation, the IRC allows a REIT to deduct from its income the dividends it distributes to its shareholders, and the REIT must distribute at least 95 percent of its ordinary net taxable income to its shareholders. (13) The REIT must pay regular corporate tax on the income that it does not distribute to shareholders. (14) For federal tax purposes, individual shareholders must treat REIT dividends as ordinary portfolio income. (15) Corporate shareholders are not entitled to deduct REIT dividends. (16) While the IRC does not allow corporations to use REIT dividends as a deduction for dividends received in calculating federal tax deductions, many states still grant these deductions.

    2. Development of REITs

      REITs originated in Massachusetts in the mid-nineteenth century as business trusts. (17) At the time, Massachusetts law prohibited corporations from dealing in real estate. (18) Corporations began using common law business trusts to invest in real estate and circumvent this prohibition, which became known as Massachusetts Business Trusts. (19) A Massachusetts Business Trust is defined as "an unincorporated business organization created by an instrument by which property is to be held and managed by trustees for the benefit and profit of such persons as may be or become the holders of transferable certificates evidencing the beneficial interests in the trust estate." (20)

      With its ruling in Morrissey v. Commissioner, the United States Supreme Court made the Massachusetts Business Trust a much less attractive option. (21) Prior to the Morrissey decision, business trusts were not taxed on income that was distributed to the beneficiaries. (22) However, in Morrissey, the Commissioner of Internal Revenue assessed income tax on trustees of a business trust, reasoning that the trust was doing business in a corporate capacity and should be taxed as such. (23) The Court agreed with the Commissioner and held that the trustees of the business trust should be taxed as a corporation because the trust was created to carry on business activities. (24) Holding real estate in trust lost tax advantages with the ruling in Morrissey and became less popular until 1960. (25)

      In 1960, President Eisenhower signed into law the Real Estate Investment Trusts Act ("1960 Act"). (26) Congress designed the 1960 Act to extend favorable tax treatment to REITs. (27) Regulated investment companies had received favorable tax treatment in the past, and Congress designed the Act to give similar treatment to REITs. (28) Congress also desired to increase the available funds for real estate development. (29)

      This legislation was especially significant to small investors. Congress noted that giving favorable tax treatment to REITs was desirable because it would allow investors with limited resources to take advantage of some of the benefits of investing in real estate that would otherwise only be available to those with larger resources. (30) These benefits included "diversification of investment which can be secured through the pooling arrangements; the opportunity to secure the benefits of expert investment counsel; and the means of collectively financing projects which the investors could not undertake singly." (31) REITs allowed small investors to obtain these benefits "without being exposed to the risks of an active real estate business." (32)

      In creating the 1960 Act, Congress set up the strict structural and operational regulations for REITs in order to ensure that the investors would be protected against business risks and so that REITs would act as passive investment entities. (33) Under the 1960 Act, Congress intended for REITs to earn money by renting out space and/or collecting interest on mortgages. (34) Under the qualification regulations, REITs were prohibited from managing or operating the property, except through an independent contractor. (35) Because REITs were designed to be passive investment entities, Congress felt that it was appropriate not to tax REITs at the corporate level. (36) Instead, REITs were allowed to deduct the amount paid as dividends to its shareholders. (37)

      The Tax Reform Act of 1986 changed the role of REITs. (38) With the passage of the Tax Reform Act, REITs were given a more active role in the management and operation of their properties. (39) With the loosening of the regulations on REITs and eliminating some of the tax benefits of holding real estate in a partnership, REITs gained popularity. (40) Not only were small investors taking advantage of the tax benefits of REITs, as originally envisioned by Congress, but sophisticated corporate investors also began to take advantage of these tax benefits. (41) As will be discussed in the following section, corporations began using REITs as a means of avoiding tax liability at the corporate level. (42)

    3. Tax Loopholes Relating to Captive REITs

      In recent years, large corporations have begun to use REITs to avoid state tax liability. Corporations can avoid state tax liability with the use of private or "captive REITs." A captive REIT is structured so that "the majority of the stock is owned by one or more shareholders who contribute the bulk of the equity to the REIT, and a small number of shares, with a relatively nominal value, is held by 99 other shareholders." (43)

      Large, multi-state retailers can use this form of REIT to avoid paying state taxes by paying rent to themselves. (44) This happens when the parent corporation sets up a captive REIT, which owns all of the real property of the corporation (such as the retail stores). (45) The corporation then sets up a subsidiary to be the primary shareholder of the REIT in a state such as Delaware or Nevada, which does not tax dividends. (46) The corporation pays rent to the REIT for the use of the retail stores. (47) The corporation is allowed to deduct these expenses off its state income tax, as business expenses. (48) The REIT then pays this income to the subsidiary as dividends and is entitled to a deduction for dividends paid. (49) Those dividends are taxable as corporate dividends by the state of the shareholder's domicile. (50) The subsidiary avoids state tax liability because it is located in Delaware or Nevada where that type of income is not taxed. (51) The income is eventually distributed back to the parent corporation, which does not pay state taxes on the income...

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