A popular tax loophole for companies investing in real estate investment trusts, or REITs, has been closed under Governor Eliot Spitzer’s new budget.
Eliminating a tax provision that allowed REIT investors to dodge taxes on dividends will prevent companies with more than $8 billion in assets from using complicated strategies to shelter income from New York State taxation.
State budget director Paul Francis said he was happy to see the elimination of the loophole when the budget was passed in April. He defined the loophole as “a provision used by a small group of sophisticated taxpayers in a way that the provision was never intended to reduce their tax liability.”
Eliminating the loophole did not sit well with many businesses, banks and investors.
“Our first argument is that they were established laws, not loopholes,” said Michael Smith, president and chief executive officer of the New York Bankers Association, a week before the budget was passed. “The REIT [law] quite frankly had been debated and proposed for elimination in the Pataki administration. We think and believe and argue that the REIT [law] should be maintained.”
REITs pay no corporate income taxes, but their dividends are counted as income for their investors. So to exploit the REIT law, large companies often put all of their real estate holdings into a REIT. The structure, called a captive REIT, is a real estate investment trust or qualified real estate investment trust subsidiary where more than 50 percent of the voting power or value of the trust is owned or controlled by a single corporation.
Spitzer estimated that eliminating captive REIT loopholes will bring the state $83 million a year.
“It can be — and is — exploited by large companies,” said Charles Failla, a certified financial planner and principal at Sovereign Financial Group in New York. “The whole reason they set up the REITs is to avoid paying taxes.”
Retailers and banks are among the businesses that have been using this strategy since the 1990s. Wal-Mart is notorious for this approach, and the company has been targeted by many state legislatures that seek to increase their tax revenues.
Under New York’s new state budget, REIT structures for corporations with more than $8 billion in assets will be phased out gradually. But for banks with under $8 billion in assets, called community banks, REITs will be maintained.
According to Jeffrey Gordon, press secretary for the Division of the Budget, the governor felt that the problems associated with the REITs needed to be fixed sooner rather than later.
“We updated our tax policy and closed outdated loopholes that allowed sophisticated taxpayers to lower their tax liability in ways not intended when the REITs were created,” Gordon said. “By lowering their tax liability, other taxpayers that were similarly situated were paying much higher effective tax rates.”
Critics say the elimination of the loophole is effectively a tax hike.
“What a budget cruncher calls a loophole, a business owner feels is a tax increase,” said Kenneth Adams, president and chief executive officer of the Business Council of New York State. “At the end of the day, they are increased costs to important sectors to the state’s economy.”
Congress created REITs in 1960 as a way to allow smaller investors to put money in a broad real estate portfolio to diversify their investment risks.
After a boom in REITs in the early 1990s, big accounting firms including Ernst & Young and KPMG LLP figured out that on the state level, they could pair the tax break on REIT dividends with a separate tax rule that allows companies to receive dividends tax-free from their subsidiaries. With the REIT as a subsidiary itself, two rules aimed at avoiding double taxation could be combined to effectively avoid any taxation at all.
The new budget also raises taxes on larger banks with real estate investment trusts by phasing out, over four years, the deduction for dividends from captive REITs. The final change is scaled back from Spitzer’s executive budget proposal, which would have eliminated the REIT deduction immediately.
Despite closing REIT loopholes, Spitzer said businesses will benefit from the budget. The governor said the budget provides $150 million worth of targeted business tax relief in the form of a rate cut for all corporations, banks and insurance companies, and targeted relief for manufacturers and high-technology companies.
Life will go on for investors
According to Ron Kuykendall, vice president of communications at the National Association of Real Estate Investment Trusts, the REIT issue won’t affect the industry.
“This has not been something that has impacted our members. We are an industry of approximately 200 publicly traded companies, mostly listed on the New York Stock Exchange, with a collective $417 billion in market capitalization and more than $3 billion in average daily trading volume,” he said. “The changes in the budget will not keep the companies from investing.”