All state income tax systems in the United States, including ours, have a set of rules that are used to figure out which state has the primary right to tax income.

For example, most tax systems provide that rent from real property is sourced at the location of the property, so if a couple in Florida rents out a property they own on Maui, they can expect to pay our general excise tax and our net income tax on that rent.

These sourcing rules, which do vary by state but are relatively consistent, are there to assure consistent and fair treatment between states.

Tax money in a jar

Sourcing rules, which vary by state but are relatively consistent, are there to assure consistent and fair treatment between states.

Nevertheless, sourcing rules can yield strange results. In Hawaii, there is a Supreme Court case ruling that when real property is sold on the installment basis under an “agreement of sale” (where the seller remains on the title until the price is paid although the buyer can live in the house), the interest on the deferred payments is Hawaii source income and is subject to our net income tax and our GET.

There is also a Hawaii Tax Appeal Court case holding that when the seller instead finances the deal by taking a purchase money mortgage on the property, and does not remain on title, then the mortgage interest is sourced to the residence of the seller, who in that case did not live in Hawaii.

In the latter case, the court applied the rule for income from intangibles such as interest, royalties, and dividends, which says that income is sourced to the residence of the recipient unless you can connect it with some active business that the recipient is conducting somewhere else.

Real estate investment trusts or REITs, which we’ve discussed before and are now the subject of some bills in the Legislature, are source shifters.

For income tax purposes, they take in rent income, which is sourced to the location of the property being rented. They don’t pay income tax on that income as long as they distribute the money to their shareholders as dividends.

The dividend income of their shareholders, on the other hand, is generally sourced to the residence of the shareholders. So the income, that otherwise would be taxed by the state in which the property is located is instead taxed in the states in which the shareholders live.

There are other kinds of entities that are not themselves taxed. Partnerships and Subchapter S corporations don’t have this issue because the partners in a partnership and shareholders in an S corporation are considered to do the same business that the entity is doing, so the source of the income doesn’t change.

Mutual funds, also known as regulated investment companies, do have the potential for source shifting, where the state in which the company is headquartered loses the ability to tax the investment income in favor of the states in which the company’s shareholders reside.

Was source shifting an accident? Probably. Congress, which enacted REITs in 1960, doesn’t care about source shifting between states because the IRS gets to tax the shareholders in any event. If the dividend is paid to someone outside the country, federal tax is withheld so the Treasury is able to get one level of tax on all of the REIT’s earnings.

For some states, however, the consequences of source shifting are much more pronounced. In particular, it so happens that REITS own lots of property in Hawaii and there don’t seem to be many REIT shareholders in Hawaii — so Hawaii gets the short end of the shift.

Whether that continues to be the case will be something that the Legislature will be considering.

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