REITs - Investing, Pros & Cons and Taxation

The previous article dealt with structure of an REIT. Here, we will examine the pros and cons of investing in the units will help you make an informed decision and the taxation of income accrued from REIT will help you in your tax planning.

How to invest in REITs –

There are two ways by which an investor can invest his funds in a Real Estate Investment Trust –

1. Initial Public Offer (IPO) -  An IPO the process by which the trust offers its units to the public for the first time by listing on a stock exchange. An IPO has a price band and the units are to be purchased in lots.

Eg – When the first REIT of India was listed on the stock exchange, the price band for 1 unit was Rs. 300/- and the minimum bidding was of 1 lot of 800 units and its multiples. That means the minimum amount required for investing was Rs. 2,40,000 (Rs. 300 * 800 units).

2. Secondary Market - Once the trust has been registered on the stock exchange, its units are freely traded on the secondary market i.e. the stock exchange. Investors can easily purchase or sale the units on the stock market, just like stocks of companies. 

Pros and Cons of Investing in REIT –

Investing in an REIT has its own advantages and disadvantages. It is better to be aware of these before investing your hard-earned money. Some of the Pros and Cons are –

1. Pros - 

    a. Dividend Income - REITs are required to pay 90% of their income as dividend to their unit holders. This ensures regular cash flow for the investor and a high dividend yield on investment

    b. Liquidity - Unlike traditional real estate investment, REIT units are liquid in nature and can be easily purchased or sold as per the convenience of the investor

    c. Long-Term Cash Flow - The rental properties assets of an REIT are secured by long -term leases which ensures a regular cash flow for the investor.

    d. Diversification - REIT can help investors diversify their investment portfolio from traditional investments instruments.

    e. Transparency & Accountability - The REITs are governed by SEBI and are subject to stringent laws and regulations. This ensure greater transparency and accountability.

2. Cons - 

    a. Little scope for expanding portfolio - As the REITs are required to pay out 90% of income as dividend, there is little money left for the trust to expand its asset portfolio. This hinders the growth of the REIT.

    b. Low Occupancy - The success of the REIT is dependent on fixed rental income and high occupancy rates. A fall in the occupancy rate will lead to low rental income which can reduce the profitability of the REIT.

    c. High Interest Costs - REITs must raise debt for expanding their portfolio. High levels of debt mean higher interest cost which can lead to a cash crunch, if not managed properly.

    d. Property Taxes - A increase in the property taxes by the government will have a negative impact on the earnings of the trust. A major hike may also lead to the trust in selling some of its assets with high property taxes.

    e. Stringent Rules & Regulations - REITs are governed by SEBI and must adhere to strict rules and regulations if they are to be listed. This makes forming an REIT difficult as per are reluctant to get involved in too many compliances.

Taxation of REITs –

The concept of taxation of REITs and InvITs was first introduced in Finance Act, 2014. The charging section for REITs is Section 115UA of the Income Tax Act, 1961.

1. Capital Gains Tax - 

    a. Sale and purchase of listed units of trust to attract the same capital gain tax as those in case of equity shares. Units held for a period of more than a year shall be treated as Long-Term Capital Gain (LTCG) and taxed at 10% for gain over Rs. 1 lakh. Units held for less than a year shall be treated as Short-Term Capital Gains (STCG) and taxed at 15%.

    b. Capital gain arising to sponsor on exchange of units of SPV for units of business trust shall be deferred. The tax shall be charged sale of units by the sponsor.

For computing capital gain, the cost of the shares to the sponsor shall be considered as the cost of the units sold and the holding period for the units shall also include the holding period of the shares.

    c. On sale of an asset by the trust, the capital gain shall be taxable in the hands of the trust at applicable rates.

If the earnings from the capital gain are distributed to the unitholders, the capital gain shall be exempt in the hands of the unit holders.

2. Tax on Rental Income and Interest Income - 

    a. REITs have been conferred hybrid pass-through status. Any interest or rental income earned by the trust through the SPV shall pass through to the unit holders in the form of interest or dividend. The income shall be taxable in the hands of the  unitholders and NOT the trust.

    b. Rental incomes directly received by the trust shall be exempt in the hands of the trust u/s 10(23FCA). It shall be chargeable to tax in the hands of the unitholders on distribution.

3. Other Incomes - 

    a. Any dividend distributed by the SPV shall be exempt in the hands of the trust and the unitholders. The SPV would be liable to pay Dividend Distribution Tax (DDT) on that amount.

    b. Any other income earned by the trust, except those mentioned above, shall be taxable in the hands of the trust at Maximum Marginal Rate (MMR).

4. TDS Provisions - 

    a. On distribution of rental income directly received by trust to its unitholders - 

        i. TDS @ 10% for residents' u/s 194LBA

       ii. TDS @ 30% for non-residents'

       iii. TDS @ 40% for foreign companies.

    b. No tenant is required to deduct TDS u/s 194-I on payment of rent directly to the REIT.

The only aspect left for us for an REIT investment is – “How to choose a good REIT” and the returns provided by REIT in comparison with other asset classes. This shall be taken up in the next article.