What is a REIT and how does it work?

REIT stands for Real Estate Investment Trust. A REIT will be a listed company owning, managing and earning rental income from commercial or residential property. It will be required to distribute most of its income profits. In return, a REIT should be exempt from corporation tax if the legislative conditions are met.

REITs will enable investors to share in property income and capital growth through investing in shares in a company with a more tax-efficient profile than standard companies. There is no ‘double taxation’ of income and gains that occur when a company’s profits suffer tax and are taxed again when distributed as dividends.

How did REITs come about and who will be interested?

The UK government’s interest in REITs was initially spurred by economist Kate Barker’s Review of Housing Supply, which proposed them as a partial solution to the UK’s housing shortages. The government objectives were extended to improving the flexibility and efficiency of the commercial property market and giving greater access to smaller investors. After lengthy consultation between government and the property industry, the legislation was included in the Finance Act 2006.

Many large UK-listed property investment companies are expected to convert to REITs on or after 1 January 2007. Other listed and private companies will need to consider their options in the changed market. Businesses outside the property industry that own a considerable amount of property may also see REITs as a means of releasing value hidden in their assets.

So what are the nuts and bolts of a REIT?

UK REIT will be a UK tax-resident company, listed either on the main list of the London Stock Exchange or on an overseas exchange recognised by the UK government. It will be exempt from corporation tax on rental income and capital gains, and required to distribute 90% of taxable rental profits each year (gains may be reinvested).

Companies that convert will have to pay a one-off tax charge of 2% of the value of their property investments in return for future tax exemption.

For investors, REIT distributions will be taxed as property income according to their status. UK REITs are required to withhold tax on distributions to taxpaying investors, satisfying the basic rate liability (currently 22%). There will be no tax for investors holding REIT shares through their ISA or SIPP, or for other UK-exempt investors.

Legislation has been put in place to deter investors from owning substantial holdings in a REIT and limit the loss of tax revenues if overseas investors could otherwise claim relief under tax treaties.

What is the advantage for investors of investing in a REIT?

A major advantage is that tax on REIT returns will be more closely aligned with tax on direct investment returns. Importantly, REITs will give the chance to invest in a professionally managed, diversified portfolio, offering regular income returns and strong corporate governance – an investment which should be more easily tradeable and with lower transaction costs.

Direct property ownership versus REITs. Which do you think is better?

Many people like to see the tangibility of their investment – the bricks and mortar – but this is not always the best investment option. Direct investment can provide significant returns for the professional investor. Individuals investing in property that is let to unquoted trading businesses can sometimes also benefit from a lower effective tax rate on capital gains.

Of course, one person’s dream might be another’s nightmare. The major drawbacks are that direct investment usually requires a considerable capital outlay, lacks liquidity, involves high transaction costs and is management-intensive and, consequently, has the potential to be less secure.

So it depends largely on the investor’s circumstances and attitude to risk. As with any investment, investors should always seek professional advice.

REITs seem like a sure thing. Are there any drawbacks?

For the typical investor, there are no particular drawbacks, but caution is always advised as the value of any investment can go up as well as down. REITs may not suit overseas investors because capital gains, if distributed, is taxed as income and because the 10% holding restriction prevents them obtaining maximum relief from UK tax under double tax treaties.

For new companies or groups, there are potential barriers to success. Companies registered on AIM and OFEX cannot become REITs. No company can become a REIT until listed and the cost of obtaining and complying with a UK listing will be a barrier to entry for many.

So, if you can’t invest in a REIT until 1 January 2007, what next?

AWhile you wait, consider the potential risks involved and if they are right for your investment portfolio. Above all, seek professional advice.

Marion Cane is property tax director at Grant Thornton