Tax Benefits of REIT investments

Real Estate Investment Trusts (REITs) has gained prominence as a feasible investment option especially for small investors. These trusts which were formerly considered to be smaller offshoots of sector-related unit investment trusts gained in popularity following the move taken by the Global Industry Classification Standard to grant REITs the status of a separate asset class. It can be considered an ideal investment option for the average investor to gain profits without directly acquiring property. Moreover, their unique tax implications and the tax benefits they offer to regular investors is worth mentioning.

What is REIT?

REIT is a real estate company which offers common shares to the general investor. In this context, REIT is similar to any other shares that are held by individuals in any operating company. However, compared to other stocks, what is unique about it is that it should primarily manage groups of properties producing income, the profits of which should be distributed as dividends among investors.

How does it function?

Initially a REIT trust company accumulates a pool of money through Initial Public Offering (IPO). The money accumulated thus is utilized to purchase, develop, maintain and sell assets in real estate. The IPO generated from REIT is similar to any other security offering with similar rules, requirements and regulations governing them. However, instead of purchasing shares in a single company, an investor who owns a REIT unit buys a portion of a managed real estate pool. This real estate pool subsequently generates income to the REIT holder through renting, leasing and selling of real estate property which is then directly distributed to the REIT holder on a regular basis.

Tax Benefits in REIT

·         Trust Level Tax Benefits:

Since REITs follow the same rules as other unit investment trusts, they are taxed initially at the trust level and then to the beneficiaries. However, taxation of REITs follow the same method of self-assessment through valuation and accounting rules, as in the case of corporations. However, contrary to how other trusts operate by extending dividends to unit holders after profits are calculated, unit holders of REITs derive cash inflow directly.

Despite REITs being similar to other unit investment trusts on various counts, there are a couple of aspects that set it apart:

1.       REITs treats rental income as business income as the government considers rent accrued to be the business of REITs. Accordingly, all expenses related to rental activity can be deducted as in the case where business expenses are written off by corporations.

2.       Current income distributed to unit holders is not taxed to REITs unless such income is distributed to a Non-resident beneficiary. In such cases, 30 per cent withholding tax is charged on such income for ordinary dividends, and 35 per cent in the case of capital gains, unless there is a treaty to the contrary.

Generally, REITs are exempt from taxation at the trust level provided they distribute atleast 90 per cent of their income to unit holders.

·         Unit holder Level Tax Benefits:

Unit holders are taxed on REIT dividend payment only as ordinary income, unless they are “qualified dividends” which as taxed as capital gains. Normal dividends are taxed at the unit holders top marginal tax slab. Moreover, part of the dividends paid out by REITs consists of a non-taxable return of capital component. This reduces the unit holders taxable income in the year in which he receives the dividend and also defers tax payment on that potion until the sale of the capital asset. The tax benefits offered by REITs translates into higher yields for unit holders who are looking for higher returns from them at relatively high stability. They can even expect a negative cost basis if they are willing to hold onto the units for a considerably long period.