A Real Estate Investment Trust - or REIT for short - is a property investment company which pays no tax on the income and capital gains derived from its rental assets. Instead, the tax is effectively transferred to the shareholders, who are treated as if they had invested directly in the underlying properties.
In this introductory article, we shall look at how the tax legislation achieves this result. We shall go on to look at other aspects of the REIT regime in subsequent articles.
Not everyone can be a property landlord. It takes time, effort and money. For an individual investor who can afford to set aside a smaller sum, it makes sense to invest in a vehicle such as a REIT, where all the hard work is taken care of by those who have the requisite experience of managing a property business.
Technically, a REIT is a company, listed on the stock exchange as well as other junior and overseas markets. It is not regulated by the Financial Conduct Authority, and so it isn't classified as a fund such as an OEIC or a unit trust. However, a REIT shares the same features and purpose of a fund, in that it involves investors pooling their resources so as to provide them collectively with opportunities which might not have been open to them as individuals.
For example, by investing in a REIT or other property vehicle, one can have a stake in many of the office properties in the City of London, or Canary Wharf if it ever comes up for sale. As well as the generalist REITs such as British Land and Hammerson, there are companies that cater to specialist sectors. Local Shopping REIT specialises in shopping centres, while Primary Health Properties owns doctor's surgeries, where the rents are effectively backed by the government1. These sectors cannot be easily accessed by the individual investor.
Even larger, sophisticated investors such as pension funds and insurance companies can benefit. A lot of property deals involve such large amounts of money that even these investors find it makes sense to pool their resources rather than go it alone.
A further advantage is that by investing in a single equity stake, an investor is automatically provided with a diversified property portfolio. As a consequence, risk is spread amongst the underlying holdings.
Since a REIT is intended to be a proxy for its investors, it is important that it is as tax transparent as possible. In particular, it is important that investment decisions taken at the fund level should not be distorted by tax considerations.
We shall now look at how this is achieved. In the following discourse, one should have a mental picture of the REIT as a landlord, managing its property portfolio, and receiving rental income from its tenants. How is this income and the consequent tax liability passed on to the investors?
(The statutory references in this article relate to two types of REIT - a single-company REIT and a group REIT. The distinction isn't important for the purposes of this discussion, but we shall look at this in more detail in a subsequent article).
REITs are exempt from capital gains incurred in respect of the assets of the property rental business2. The tax is not imputed to the shareholders as would be the case with a partnership - instead, the investors pay CGT only when they sell their shares.
The capital gains exemption is an important tax break shared with other types of investment fund such as investment trusts, unit trusts and OEICs3. We have already noted that a fund is a proxy for its shareholders - accordingly, it makes sense that any capital gains accrue in the fund and are realised only when investors actually sell their shares.
There are two further points worth mentioning:
However, unlike other fund vehicles, such as investment trusts and authorised investment funds, the exemption doesn't extend to all assets in the portfolio. So shares in other property companies, or holdings in property unit trusts are not covered, even though these vehicles also invest in real estate (we shall see the reason why in a later article).
Rental profits are taxed in the following way:
The overall effect is that each individual shareholder is treated as if he were a landlord running his own individual property portfolio. The REIT is no more than a conduit to channel the profits from its tenants to its investors.
In order to ensure that this transfer of tax liability from the fund to the investors is effective, two further conditions need to be fulfilled:
The requirement to distribute a substantial amount of its profits is a condition that REITs share with other investment vehicles. However, for a REIT, this can be a disadvantage if funds are needed to reinvest in the business - most normal companies - even the most mature ones - retain a proportion of their profits for this very purpose.
This is not an issue for investment trusts and authorised funds investing indirectly through equities. These funds do not actually run the underlying property business. It is the companies in which they hold an equity stake that collect the rents, manage and maintain the buildings, and invest in new infrastructure. The companies at the operating level will have already retained part of their profits before paying a dividend to the fund - there is no need for further profit retention when the fund passes on this dividend to its own investors.
This can be illustrated by the following diagrams. In the first example, we see how a REIT distributes its profits from a directly held property.
The second diagram shows the position for an investment trust, holding an equity stake in a property company. We assume that the latter has a 50% payout ratio.
One way in which this issue can be mitigated is for the REIT to pay a stock dividend11. This is a recent innovation, enabling cash to stay in the fund - this can be used to maintain existing properties or for new investment opportunities, without having recourse to third party borrowing.
For investors, there are both pros and cons:
Unlike a normal dividend, the property rental part of a REIT distribution is subject to withholding tax at the basic rate13, with a number of exceptions14. These include UK corporate investors and tax exempt bodies such as local authorities, registered pension schemes and charities. A REIT can also be held in a tax wrapper such as a PEP, ISA or Child Trust Fund - these also qualify to have the dividend paid gross.
The requirement to withhold tax extends to non-resident shareholders. However, unlike the case for direct property investment, the latter class of investor cannot apply to have their property distributions paid gross under the non-resident landlord scheme15.
This diagram sums up the position.
In the above analysis, we have focused only on the REIT's property rental business, in order to illustrate how the relevant profits are taxed as they flow from the tenants to the fund, and from the fund to the ultimate investors.
In practice however, a REIT may have other sources of property related earnings, and so the dividend payout will consist of a mixture of rental and other income. In these circumstances, the dividend is streamed into its constituent parts16. Only the rental part is subject to the rules on withholding and deemed to be property income in the hands of investors - the remainder is treated as a normal dividend.
What types of property asset can a REIT invest in, and do they benefit from the tax exemption? We have already noted that a REIT can hold property and shares in other REITs, but are there any other types of investment that are permitted, and if so, under what conditions?
We shall look at these questions more closely in a subsequent article.
The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.
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