captive REIT

In an effort to avoid state corporate income taxes, corporations have been employing captive REITS to save money. Here is how a captive REIT works: A subsidiary pays rent to a REIT, which is entitled to a tax break if it pays its profits out in dividends. The REIT is 99% owned by another subsidiary. The other 1% is owned by at least 99 other employees of the company, since REITS need at least 100 shareholders to gain tax benefits. This subsidiary receives the REITS dividends tax-free, and the company gets to deduct the rent from state taxes as a business expense, even though the money has stayed within the company.

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.

Congress created REITs in 1960 as a way to allow smaller investors to put money in a wide portfolio of commercial real estate, spreading their risk. Congress also gave them a tax benefit: REITs aren't subject to corporate income tax on the profits they pay to shareholders as long as they pay out at least 90% of the profits. The shareholders still usually get federally taxed on the dividends, which still count as income for them.