By Suraj Nangia, Partner and Sandeep Jhunjhunwala, Director, Nangia Advisors (Andersen Global)
Real Estate Investment Trust (REIT) is a globally accepted investment vehicle for passive participation in real estate properties. First conceptualised in the United States, REIT has been in existence in several developed and emerging economies now, providing a stable investment alternative for retail investors. Modelled similar to mutual funds, REIT, as an investment concept, provide investors with an opportunity to own underlying commercial real estate and access dividend-based income from rent-yielding assets and capital appreciation from property prices. REITs provide a way for individual investors to earn a share of the income produced through commercial real estate, without actually having to directly own commercial real estate, which is a capital-intensive investment. The REIT regulations issued by the Securities and Exchange Board of India (SEBI) have created a detailed ecosystem by outlining the role and responsibilities of each stakeholder in the REIT structure and laying down the conditions for operating and managing a REIT in India, including asset and income restrictions, net asset value declaration, audits, insurance, income distribution and governance aspects. The Embassy Office Parks REIT IPO, which flagged off REIT listing in India, witnessed sluggish response by the sceptical individual investors, whereas the institutional investors lapped up the offer passionately, with an overall subscription of 2.57 times as per the NSE data. The quota for institutional investors was subscribed 2.15 times and non-institutional 3.10 times of the issue. Though this oversubscription of REIT is a very encouraging sign for the commercial real estate sector, a dipstick analysis of the subscription records would primarily reflect the lack of awareness among the individual (non-institutional) investors and “trust deficit” associated with real estate sector. While the real estate stratosphere has been institutionalised by the Real Estate (Regulation and Development) Act of 2016, the commercial domain in Indian real estate, which is revolutionised by equity REIT structure now, would operate under the aegis of SEBI, giving it the much-needed operational transparency. Residential real estate segment, which is facing the heat on account of a dearth of institutional funding, is not included under REIT coverage in India.
One of the key investment conditions for REIT is that at least 80 per cent of REIT assets are to be invested in completed and rent-generating properties. The balance 20 per cent of investment could be made in assets that are under construction, debt (listed and unlisted), mortgage-backed securities, equity shares of listed companies deriving 75 per cent or more of their income from real estate activities, Government securities etc. The distribution conditions specify that at least 90 per cent of net distributable cash flows of the REIT shall be distributed to the unitholders. Such distributions should be declared once in 6 months every financial year and paid within 15 days of declaration. In case of sale of property or equity interest in SPV, proceeds are not required to be redistributed to the unitholders, provided that there is a plan to re-invest such proceeds within a period of 1 year. Else, 90 per cent of the proceeds are required to be redistributed to the unitholders. The investors should note that in the real estate sector, both rental income and capital appreciation from property depends on its location and surrounding infrastructure. REITs, as a mode of indirect investment in the sector, pacify these risks through a diversified portfolio of rent-yielding properties.
REITs are structured as flow-through or hybrid pass-through entities to avoid the double taxation of income and facilitate distribution of the majority of income cash flow to investors without taxation at the collective level. The special taxation provisions under Sections 10(23FC), 10(23FCA), 10(23FD), 111A, 112A and 115UA of the Income Tax Act, 1961 deal with the tax treatment of various streams of income accruing to unitholders of REIT. In summary, interest from SPV is taxable as interest income for the unitholder and withholding tax at the rate of 10 per cent (5 per cent for non-resident unitholders, subject to tax treaty) is to be deducted on distribution under Section 194LBA of the Income Tax Act. Long term capital gains earned by the unitholder on sale of REIT units (where the holding period of units is more than 36 months) is taxable at the rate of 10 percent (plus applicable surcharge and cess) for gains over INR 1 lakh, whereas short term capital gains for sale of units held for up to 36 months are taxed at 15 per cent (plus applicable surcharge and cess). No tax breaks are available under Sections 80C to 80U of the Income Tax Act for capital gains tax. On dividend distribution by the SPV, dividend distribution tax at 30 per cent as per Section 115-O of the Income Tax Act is applicable and dividends are exempt in hands of unitholder. Onward distribution of rental income from property held directly by REIT and received by unitholders is construed as deemed income, retaining the same character and taxable at applicable slab rates and residential status.
Correspondingly, any distributions by REIT other than those which are characterised as interest or rent does not attract any withholding tax. Where the unitholder is a domestic company, the capital gains earned would be subject to Minimum Alternate Tax (MAT) under Section 115JB of the Income Tax Act. However, MAT paid by such companies would be available as credit, which can be set-off against the future income tax liability of such company for a period of up to 15 years as per Section 115JAA of the Income Tax Act.
A relatively high minimum investment (INR 2 lakhs approximately) seems to be a clear deterrent for retail investors to participate in REIT, a new asset class to experience and explore. The Indian REIT regime aims to offer an organised and professionally managed ecosystem for retail investors and an exit platform to ease out liquidity burden. Though the Government significantly cleared the regulatory logjam through deliberative consultations in the last few years, a smoother legal obligation (stamp duty alignment etc) and logical tax structure (ironing out income tax issues at sponsor/ SPV level, leading to single point of taxation) might make this investment more worthwhile and appealing for the investors. The acumen of investing in real estate through REITs should gradually tide over the sentiment of having own property, similar to investing in gold bonds rather than buying physical gold. Time would testify this transition.