On April 30, 2019, the Hawaii legislature approved a bill (SB 301) that, if enacted, would temporarily disallow the dividends paid deduction (DPD) for real estate investment trusts (REITs) for Hawaii state income tax purposes for tax years beginning after December 31, 2019. The disallowance provisions would be repealed on December 31, 2023.

The bill has been sent to Hawaii Governor David Ige for his consideration. It is not clear whether he will sign or veto the bill. Governor Ige has until July 9, 2019, to sign or veto the measure. If the Governor does not act on the bill, it will become law without his signature.

History of Hawaii REIT legislation

One of the distinguishing tax features of REITs from other corporate taxpayers is that they may deduct dividends paid to their shareholders. For a REIT to claim the DPD, it must distribute 90% of its taxable income. "Taxable income" is calculated before DPD and excludes any net capital gain, as well as net income from foreclosed properties. See generally IRC Section 857. For most REITs, the DPD almost always offsets their taxable income so tax is usually only paid at the shareholder level on the dividends received from the REITs. Every state generally follows this special federal income tax treatment of REITs (with the exception in some states of special rules for disallowing the DPD received from so-called captive REITs).

For the past few years, proposals have been floated in the Hawaii legislature that would repeal the DPD for REITs for state income tax purposes. Proponents argue that most of the investors in Hawaii REITs are not subject to Hawaii income taxation and thus, the REITs and their investors escape Hawaii income taxation. The proponents, however, fail to point out that many Hawaii investors invest in REITs that are located outside of Hawaii and thus, pay tax on the dividends they receive from the out-of-state REITs.

In 2014, HB 1726 passed the House, but was deferred by the Senate. In 2015, several bills were introduced by members of the House and Senate to do the same. While none of the repeal bills were approved, a bill (SB 118) was enacted that funded a study on "the impact of real estate investment trusts in Hawaii and the possible effect of repealing the dividends paid deduction for real estate investment trusts."¹

Following the issuance of the report, legislation to repeal the REIT DPD for Hawaii income tax purposes was introduced in 2017, but ultimately failed to pass. Legislation again was introduced in 2019.² As originally proposed, SB 301 would have permanently repealed the REIT DPD; as finally approved, however, the REIT DPD disallowance would be temporary, applying to tax years beginning after December 31, 2019, and sunsetting on December 31, 2023.

Implications

The DPD's repeal would result in REITs with Hawaii nexus (e.g., equity REITs with real property located in Hawaii, mortgage REITs with economic nexus in Hawaii) being subject to tax on REIT taxable income³ apportioned to Hawaii. Eliminating the DPD also may result in REITs falling into higher Hawaii corporate tax marginal rate brackets, the highest of which is 6.4%.

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ENDNOTES

¹ 2015 Haw. S.B. 118, Section 1.

² Legislation has also been introduced, but ultimately did not pass, to effectively treat a REIT as a pass-through entity for Hawaii income tax purposes, with a requirement placed on the REIT to withhold Hawaii income tax on behalf of its shareholders.

³ Hawaii Rev. Stat. tit. 14, Section 235-71(d).