Cash Flow

Are Captive REITs Kaput?

States in search of tax revenue are probing whether capitve real estate investment trusts pass muster.
Karen M. KrollJune 27, 2007

A growing number of state officials are
taking aim at an entity known as captive
real estate investment trusts. Their claim?
That a captive REIT’s sole purpose is to
enable companies to shirk state incometax
obligations. In their sights are companies
like AutoZone and Wal-Mart.

While captive REITs come in several
varieties, they often work like this: a
firm shifts ownership of its real estate
assets to the captive REIT. Then the
individual stores actually rent their
spaces from the REIT, which means
they can deduct their rent expense and cut their taxable
income. By law, REITs effectively don’t
pay federal income tax, but can deduct
their dividends to shareholders if they pay
out at least 90 percent of their portfolio,
says Michael Mazerov, senior fellow with
the Center on Budget and Policy Priorities,
in Washington, D.C.

The problem at the state level,
however, is that REIT shareholders can
deduct the dividend income from their
state taxable income. By establishing a
REIT, a company not only gets to deduct
the rent expense it pays itself, it can also
exclude from its taxable income the dividends
that the parent company receives.

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Nobody knows just how much
states are losing as a result of captive
REITs. However, a 2007 report by Mazerov
shows that corporate income tax (in
the 45 states that levy it) supplied 6.5 percent
of states’ tax revenue in 2005, compared
with 10.2 percent in 1979. According
to the study, one likely reason is the use of
tax shelters such as captive REITs.
States are fighting back. So far this
year several states, including New York,
Maryland, Massachusetts, and Rhode
Island, have passed or considered legislation
to close the captive REIT loophole.
Says Paul Sander, a partner with Strasburger
& Price in Texas: “The window is