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.
II. 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.
A. 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. …