Finance Act 2023: How your income from Reits and InvITs will be taxed

The amendments to the Finance Bill 2023, passed by Lok Sabha and that received the President’s assent, include changes to the budget proposal pertaining to taxation of real estate investment trusts (Reits) and infrastructure investment trusts (InvITs).

Now, the ‘loan repayment’ distribution component from Reits and InvITs need not be treated as income from other sources, as stated in the Budget. According to the Finance Act 2023, such income gets capital gains tax treatment for a certain number of years (explained later).

This amendment brought relief to investors as well as industry players as capital gains attract just 10% tax if held for the long term (36 months). This is against the tax on ‘other income’ that is at individual’s slab rates, which can go to as high as 42% (including surcharge and cess) for those in the higher tax bracket.

What happened?

Reits and InvITs invest in income generating commercial real estate properties and infrastructure assets via special purpose vehicles (SPV) through equity or debt instruments. Any income distributed by these trusts to its unit holders must be in the same nature and in the same proportion as distributed by the SPV to the business trust.

That is, if the SPV pays interest amount to the trust for the debt taken, that amount has to be given by the trust to the unitholders in the form of interest income only. Since the trusts are given a pass-through structure, such income is taxable in the hands of the unit holders.

These business trusts - reits and invits - are mandated by market regulator Sebi to distribute at least 90% of the cash available to unitholders. Thus, distribution income—which comes in the form of a dividend, interest, rental income or loan repayment to unitholders—forms a significant share of the return from these trusts. The distribution yield, which is calculated by dividing the annual distribution paid by the trust with the share price, indicates the approximate return an investor can expect from such investment every year.

Dividend income is exempt in the hands of unitholders, in most cases. However, if the SPV opted for a lower tax regime, dividends along with interest/rental income is taxed at the slab rates applicable to an investor.

Before Budget this year, there was no provision in the Income Tax Act for the ‘loan repayment’ component of the distributed income from trusts. Some investors treated it as exempt income.

To plug this loophole, the finance minister on February 1 proposed that such income has to be taxed as part of ‘income from other sources’ of unitholders that attracts tax at slab rates of an individual.

If this would have become effective, the post-tax distribution yield from these trusts will come down by 100 basis points. One basis point is one-hundredth of a percentage point.

The industry experts expressed their concern that it is not fair to treat an income in the form of capital gains as ‘other income’ that attracts taxation at slab rate.

The government paid heed to the industry plea as it modified the Budget proposal. The amended tax rules indicate that the amount received as ‘loan repayment’ must be reduced from the cost of acquisition at the time of sale of unit by the investor.

For example, you bought a unit of a reit at ₹400 and sold it after 3 years at ₹500 in the secondary market. During the period of your holding, say, the reit distributed ₹50 as ‘loan repayment’.

To calculate capital gains at the time of sale, you need to reduce ₹50 from your cost of acquisition of ₹400, which would come to ₹350 per unit. Thus, your capital gains will be ₹150 per unit ( ₹500 - ₹350) and not ₹100 ( ₹500 – ₹400).

Effectively, the loan repayment component will be taxed as capital gains at the time of sale of units.

But that’s not all. Just like with every tax rule, this provision is not without ifs and buts.

The capital gains tax treatment for ‘loan repayment’ component is not forever. It is only until the total of such amount distributed by a reit/invit doesn’t exceed its issue price.

For instance, the issue price of a reit/invit unit is ₹300 per unit. Say, you bought a unit of a trust when the total of ‘loan repayment’ component distributed by that reit/invit (from the issue date, not from the day you bought) just exceeded ₹300.

Any distribution that you will receive in the form of ‘loan repayment’, irrespective of your holding period, will be considered as income from other sources, which attracts tax at the slab rate in the year of receipt of such income.

But your predecessor, who held the unit before the sum of ‘loan repayment’ by the trust exceeded ₹300 (issue price), would be eligible to adjust such income from the cost of acquisition and treat it as capital gain at the time of sale of unit.

Now, a doubt might arise to you on how you as an investor would know whether the reit/invit distributed ‘loan repayment’ in excess of its issue price or not. That’s where the disclosures from companies come into picture. The industry players are still unsure of how, what and when such details must be disclosed by trusts and awaiting a clarity from the government.

Having said that, industry experts believe that investors need not worry about it much. This is because they opine that it would take minimum of 15-20 years for the existing trusts before the total amount paid as loan repayment exceeds its issue price.

For example, take Embassy Reit, which has distributed on an average of ₹10 per annum as ‘loan repayment’ from the listing date (issue price of ₹300). At the given rate, it would take 30 years for the company to breach the issue price (300/10).

Note, this is just an example and the actual number of years could be lower or higher depending on the distributions made by Embassy.

Those in the industry opine that it’s a long way ahead for other business trusts as well before the total of capital repayments breach the issue price.

Until then, investors in reits/invits has a reason to cheer that income received in the form of ‘loan repayment’ can be charged to tax at a concessional capital gains tax and not the slab rate. Unless, you want to ‘invest and forget’, you have a better predictability of post-tax return from your investments in business trusts now.

Having said that, investors would be better off paying attention to the details of loan repayment and the consequential tax treatment when buying or selling units of business trusts.