Taxing REITs doing business in Hawaii is matter of fairness

Loophole. Shelter. Gimmick.

Whatever you want to call it, there is a flaw in our state’s tax code that mainland investors love but Hawaii taxpayers should loathe.

For years, the out-of-state owners of Ala Moana Center, Public Storage, Bishop Square, as well as many other retail centers, office buildings, hotels and industrial parks, have paid virtually no state tax on their real-estate operations in Hawaii. Hard to believe, but it’s absolutely true.

These mainland firms manage to avoid paying state taxes by holding their assets in a real estate investment trust (REIT). A REIT, unlike other corporate entities, generally pays no tax at the corporate level, thanks to a "dividends paid deduction." Instead, Hawaii law requires that at least 90 percent of a REIT’s taxable income be distributed directly to shareholders, who will then pay income tax on those dividends.

The flaw in this design, however, is that because REITs are taxed only at the shareholder level, shareholders who reside outside of Hawaii typically pay zero tax in Hawaii. Instead, they pay income taxes to their state of residence.

This means a REIT shareholder can make a fortune collecting rent in Waikiki, but when that fortune is taxed, it might pay for pension benefits in Illinois or a new highway in New York.

Fortunately some of our state legislators have recognized this loophole and introduced House Bill 1726 to plug it. Passage of this bill would broaden and stabilize Hawaii’s tax base without burdening Hawaii residents or businesses with any additional tax obligations.

Conservative estimates project that closing this loophole would recover nearly $20 million in tax revenue annually. While significant, the actual figure is likely to be greater, especially considering the potential capital gains on future sales of REIT-owned property.

Obviously, the big-money mainland firms who profit from this tax loophole are staunchly opposed to closing it. Illinois-based General Growth Properties (GGP), Michigan-based Taubman and the rest of the REIT community have lobbied lawmakers to defeat HB 1726 (the bill was deferred on Friday). They argue it threatens the positive economic benefits that their current investments provide the local economy and jeopardizes future investment.

Don’t believe them.

First of all, to suggest that the economic benefits created by Ala Moana Center would vanish should its owner, GGP, be taxed like every other business entity in the state borders on absurd. GGP may decide to go back to the mainland, but it doesn’t get to take Ala Moana Center with it; the mall would stay and so would the property and general excise tax revenues that come with it.

Should GGP (or any other REIT) decide paying taxes on its Hawaii income is prohibitive, there would be a line of tax-paying non-REIT investors stretching as far as the eye can see waiting to buy those properties, thereby increasing the economic benefits to the state on any existing or future projects.

Second, recognize that Hawaii has no substitute in the real-estate world. Hawaii will remain a lucrative destination for investment dollars, given the excess profits that can be generated because of our islands’ unique culture and position geographically.

The current system of tax giveaways to out-of-state investors puts local firms at a competitive disadvantage. This is neither conducive to growth nor prudent from the standpoint of supporting the local community. Leaving this loophole open would only incentivize more firms to pack a bag full of dollars in Hawaii and fly off with it to fund some other state’s infrastructure. Supporting HB 1726 will help ensure that all businesses in Hawaii are doing their fair share to maintain our paradise.