UK tax treatment of REITs

REITs were first developed in the US but were introduced in the UK in 2007.

Qualifying property companies can elect for REIT status. The main tax implications of electing for REIT status are:

• income profits and capital gains of the qualifying property rental business of the REIT are exempt from corporation tax;
• distributions of income profits and capital gains by the REIT are treated as income from a property rental business in the hands of investors;
• 20% withholding tax is imposed on any distributions made to investors, subject to exceptions.

Qualifying for REIT status

To qualify for REIT status a company must fulfil a number of conditions in relation to itself and to its activities. A group of companies qualifies for REIT status if the group's principal company satisfies the company conditions and the group satisfies the business conditions.

In 2021, the UK government carried out a comprehensive review of the REIT rules to consider whether reforms were needed to remove unnecessary barriers to entry. The conditions that the company must satisfy in any accounting period were subsequently amended by the 2022 Finance Act. Broadly, these are:

• the company must be resident only in the UK for tax purposes;
• the company must not be an open-ended company – that is, one where more shares are created as more money is invested;
• the company's ordinary share capital must be listed on the London Stock Exchange or traded on a recognised exchange, which includes AIM - however, since April 2022, this condition does not apply if at least 70% of the ordinary shares are owned by one or more institutional investors;
• the company must not be a close company - that is, broadly, one with five or fewer controlling parties. A company will not be 'close' just because it has a participator who is an institutional investor. The company can be close for up to three years after joining the REIT regime;
• the company must have only one class of ordinary share capital and may not issue any other class of shares other than non-voting relevant preference shares; and
• the company cannot be party to a loan which carries excessive interest or interest dependent on the results of the company's business, or a loan which provides for repayment of an excessive amount.

Further conditions must be satisfied in relation to the company's property rental business (the 'tax exempt business'). These include:

• it must involve at least three single properties or separately rented units;
• no single property may represent more than 40% of the total value of the properties;
• none of the properties can be owner occupied;
• at least 90% of the profits of the property rental business must be distributed by way of dividend before the filing date for the company's tax return for that accounting period; and
• the interest cover ratio in respect of the property rental business must not fall below 1.25.

If the company carries on business other than its tax exempt business:

• profits arising from the tax exempt business must be at least 75% of total profits; and
• the value of assets held for the tax exempt business must be at least 75% of the total value of assets held by the company at the beginning of the accounting period.

The government has announced that further changes will be made to the REIT rules to address concerns regarding the complexity of the regime and barriers to its use, and to increase the attractiveness of the regime to investors. It is expected that changes will take effect from April 2023 and will include removal of the requirement that the REIT must own at least three properties where the REIT holds a single commercial property worth at least £20 million.

Tax treatment of REIT companies

Profits and gains of the tax exempt property rental business will not be subject to tax in the hands of the REIT. Profits and gains from any other activities carried on by the REIT remain subject to corporation tax in the normal way. The company will be treated for tax purposes as two different entities - the tax exempt property rental business and the non-tax exempt business. Special rules apply to how income and expenditure is divided between the two businesses.

The income from a REIT investing in another UK REIT is treated as income of the investing REIT's tax exempt property rental business provided the investing REIT distributes to its investors 100% of the property income distribution it receives from investing in another REIT.

Tax charges can arise if any of the conditions for qualifying for REIT status are breached, although some minor breaches can be disregarded.

Tax charges can also arise on the REIT if:

• the income profits of the tax-exempt business do not cover its related financing costs at least 1.25 times; or
• the REIT makes a distribution to a corporate shareholder that is beneficially entitled to 10% or more of its shares or dividends or that controls 10% or more of its voting rights.

REITs are subject to the normal stamp duty land tax rules in relation to property transactions. See our Out-Law guide to stamp duty land tax for more information.

Tax treatment of investors

Distributions from a REIT in respect of tax exempt business are known as property income distributions (PIDs).

UK-resident individuals will be subject to income tax on PIDs at the normal rate of income tax, with a current maximum rate of 45%. Corporation taxpayers will be subject to tax on distributions from the REIT at the normal rate of corporation tax (currently 19%, but increasing to 25% from April 2023) rather than being exempt from tax on dividends. For both individuals and companies this is higher than the rate of tax paid on dividends, but as the REIT itself will not be subject to tax there should be more income available to distribute.

The tax treatment of REITs is broadly comparable with direct investment in real estate. However, one disadvantage for individuals is that capital gains from the tax exempt business are taxed on the investor as income, whereas reliefs such as the annual exempt amount or capital losses could be offset against gains from a real estate investment held directly. Another disadvantage is the REIT investors cannot claim capital allowances.

PIDs are subject to a deduction of tax or withholding tax at the basic income tax rate (currently 20%). This withholding will be set against the investor's liability to tax in respect of the PID. There is a withholding tax exemption where the REIT has a reasonable belief that the person beneficially entitled to the payment is subject to UK corporation tax or is an exempt body such as a pension fund, local authority or charity.

Non-resident investors may be entitled to a reduced rate of withholding tax on their PIDs if they are eligible for relief under a double tax treaty.

Shares in REITs can be held in an ISA, PEP or child trust fund subject to the existing limits and rules for those schemes.

UK investors will be subject to the normal capital gains tax rules in relation to any gains arising on the sale of REIT shares. From April 2019, non-resident investors may also be liable to capital gains tax (or corporation tax) on gains arising on the sale of REIT shares.

Purchases of REIT shares will generally be subject to stamp duty or stamp duty reserve tax at the rate of 0.5% of the price paid, compared to a top rate of stamp duty land tax of 5% for commercial property investments held directly.

Leaving the REITs scheme

REIT status generally continues until a REIT serves notice on HM Revenue and Customs (HMRC) that it wishes to leave the scheme. However, REIT status can also come to an end automatically in some circumstances where there are breaches of the conditions or where HMRC serves notice on the REIT.

When a company leaves the REIT regime there is a deemed disposal and reacquisition by the tax exempt business of the assets forming part of the tax exempt business at market value. However, this is subject to anti-avoidance provisions. If the company has been within the REIT regime for less than 10 years then this favourable tax treatment may be modified.