Laying the bricks
Since the turn of the century, infrastructure has been considered the sunshine sector in India and has played a pivotal role in helping the country emerge as one of the fastest-growing economies in the world. The introduction of Real Estate Investment Trusts Regulations (REIT Regulations) in September 2014 marked a significant milestone in the development of the country's real estate market. The listing of Embassy Office Parks in April 2019 broke the ice in the Indian REIT industry. This was followed by the listing of Mindspace REIT in August 2020 and Brookfield REIT in early 2021.
What is a REIT?
REIT is an investment vehicle that allows individuals to invest in income-producing real estate, such as commercial buildings, hospitals, malls, and residential spaces, without physically owning and managing the property. REITs operate similarly to mutual funds, in that a fund manager pools the money of retail investors and uses it to purchase a portfolio of properties. The rental income earned from these properties is then distributed back to investors in the form of dividends. REITs can be traded on major stock exchanges and can be purchased through a brokerage account like any other stock.
Tracing the roots and foundation!
REITs were created as a way to make investing in real estate more accessible and inclusive for small investors. Before the existence of REITs, partnerships were a popular way for investors to participate in the profits of a real estate project. However, these programs were often only available to large, accredited investors, which excluded many small investors from the opportunity to diversify their investments in real estate.
REITs were first introduced in the United States in the 1960s and were designed to address the issue by allowing smaller investors to purchase shares in a trust that owns and operates income-generating real estate properties. This structure allows for more widespread ownership and participation in real estate projects and makes it easier for small investors to access the potential benefits of investing in these types of assets.
Key Advantages
REITs offer investors several benefits. Firstly, they make it more affordable for retail investors to invest in real estate, as they allow investors to purchase a share or unit in a REIT rather than having to purchase an entire property outright. REITs also simplify the investing process, as investors do not need to worry about maintaining the property or paying taxes on it. REITs are also professionally managed, which can provide investors with added peace of mind.
In addition, REITs are regulated and monitored by the Securities and Exchange Board of India (SEBI), which helps to ensure that they are operating in a transparent and accountable manner. This provides investors with a degree of protection and assurance that their investments are being handled responsibly.
Building Blocks
SEBI has put in place a number of rules for REITs in order to ensure that they operate in a fair and transparent manner. These include the following:
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80-20 Rule: At least 80% of a REIT's asset value must be in completed and income-generating real estate, with the remaining 20% able to be invested in riskier assets such as under construction buildings, equity shares, bonds, cash, or under-construction commercial property. This rule helps to ensure that the majority of a REIT's portfolio is relatively safe and stable, while allowing for some flexibility to pursue higher-risk investments.
Mandatory Distribution: At least 90% of a REIT's net distributable cash earnings must be distributed to investors in the form of dividends or interest, which is typically paid on a quarterly basis. This rule helps to ensure that investors in a REIT receive a regular stream of income from their investments.
Public Listing: All SEBI-registered REITs must be publicly listed, allowing investors to buy and sell shares or units in them like any other listed company. This provides investors with the ability to easily enter and exit their investments in a REIT.
India vs. Rest of the World
As mentioned earlier, REITs have been around for quite some time and have become a popular investment vehicle in many countries around the world. In India, SEBI introduced its draft REIT regulations in 2007. It was enacted in 2014 after being modified in partnership with stakeholders, government bodies, investors, and real estate developers to align with global norms. The first REIT in India, the Embassy Office Parks REIT, was listed on the stock exchange in 2019. Since then, a few other REITs have been listed on the exchange, but the REIT market in India is still in its nascent stages compared to other countries. The market is still evolving, but key guidelines, such as the distribution of income, are similar to other jurisdictions.
Taxation
Let’s understand tax implication of REITs in India through a story.
Mr. Sharma had been considering investing in real estate for a while and decided to invest in XYZ REIT, a company that owns and manages a diverse portfolio of real estate assets.
In the first year, XYZ REIT earned a rental income of INR 100,000 from its commercial properties and an interest income of INR 50,000 from loans provided to its SPVs. Mr. Sharma received INR 10,000 and INR 5,000 as his share of the rental and interest income, respectively. Both of these incomes were taxable at the applicable tax slab rates for residents and Mr. Sharma paid INR 3,000 (30% of INR 10,000) and INR 1,500 (30% of INR 5,000) in taxes on them, respectively.
In addition to the rental and interest income, Mr. Sharma also received dividends of INR 25,000 from XYZ REIT. In the first year, the SPV of the REIT had not opted for the lower tax regime, so the dividends were exempt from tax. Mr. Sharma received INR 25,000 as his share of the dividends and did not have to pay any tax on it.
The following year, Mr. Sharma received dividends of INR 25,000 from XYZ REIT again. However, this time, the SPV of the REIT had opted for the lower tax regime, which meant that the dividends were taxable in the hands of the unitholders at the applicable rates under the lower tax regime. Mr. Sharma received INR 25,000 as his share of the dividends and paid INR 7,500 (30% of INR 25,000) in taxes on it.
After some time, Mr. Sharma decided to sell his units in XYZ REIT. He sold the units after holding them for more than three years and realized a capital gain of INR 20,000. Under Indian tax law, long term capital gains up to INR 1 lakh are exempt from tax. Therefore, Mr. Sharma’s capital gain of INR 20,000 is not subject to tax. However, if he had realized a capital gain of more than INR 1 lakh, he would have been required to pay tax on the excess amount at the long-term capital gains tax rate of 10%.
Finally, coming to taxation regarding loan repayment, for example, Mr. Sharma bought a unit of a REIT at INR400 and sold it after 3 years at INR500 in the secondary market. During the period of your holding, say, the REIT distributed INR50 as ‘loan repayment’.To calculate capital gains at the time of sale, you need to reduce INR50 from your cost of acquisition of INR400, which would come to INR350 per unit. Thus, your capital gains will be INR150 per unit (INR500 - INR350) and not INR100 (INR500 – INR400).
