This article appeared in the October 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Michael Kemp, Barefoot Blueprint
In a recent email to my accountant I used the acronym "A-REITs". An email came back: "What are A-REITs?"
I'm sure many of you know what they are, but since my accountant had to ask, it has given me good reason to start this article with a definition.
A-REIT stands for Australian Real Estate Investment Trust. And, as the name implies, REITs pool money from lots of investors to buy real estate - be it offices, shopping centres or industrial estates. There are a multitude of REITs trading on ASX, which means you can invest in blue-chip real estate as easily as buying shares in listed companies.
(Editor's note: A-REITs provides information on the features, benefits and risks of ASX-listed Australian Real Estate Investment Trusts)
Investors often ask if they should invest in REITs or ordinary shares, and there is much to consider when answering the question. For a start, which REITs or companies are being considered, because there is a wide range on offer within each sector.
To simplify things, I am going to consider just one issue: how the Australian Taxation Office treats the returns delivered by shares and REITs, because they are taxed differently.
Taxing returns from ordinary shares
Shares deliver returns to investors in two forms - income (dividends) and capital gains (hopefully).
Dividends are taxed at the investor's marginal tax rate after franking credits (the tax already paid by the company) has been added back. For a full explanation of how this is calculated see ASX article Fabulous franking: part II.
Shares also provide returns by way of capital gains if sold at a price higher than they were acquired, after accounting for acquisition and disposal costs. Tax is typically paid on this gain and is commonly referred to as capital gains tax (CGT).
The rate of CGT varies depending on whether the asset was held by an individual(s), company or superannuation fund. For example:
- Individuals and small businesses pay tax at their marginal rate but can discount the capital gain by 50 per cent if the asset is held for more than one year.
- Companies pay 30 per cent tax (the current company tax rate) on their capital gains, independent of the period the asset was held.
- Superannuation funds pay 15 per cent CGT if the asset was owned for less than 12 months, 10 per cent if longer, and no CGT if the fund is in pension phase.
Taxing returns from REITs
Like shares, REITs deliver returns to investors in the form of income and capital gain. However, neither are taxed in the same manner as those delivered by ordinary shares. Three big differences are:
- The cost base used to calculate the CGT payable on REIT ownership is typically adjusted through time.
- Unlike dividends delivered by shares, distributions from REITs do not have franking credits attached. That is because income is not taxed in the REIT's hands. No franking credits means investors do not gross-up distributions as part of calculating their tax liability.
- Cash flows from several sources are typically included in the distributions from REITs. That is, distributions do not consist of pure rental income. And the tax treatment of the component parts can vary.
For example, a typical distribution could comprise rental income, a return of capital, a distribution of building allowances, a distribution of unrealised capital gains, and distributions from the tax differences reserve (items brought to account in different periods for accounting and income tax purposes).
It all sounds rather complicated but can be simplified from the investor's perspective. Look in the Annual Tax Statement (sent to you by the REIT) for an item referred to as the "tax deferred amount". This embodies many of the distribution components mentioned above. The good news is that this amount is not taxed in the period it is received (there is an exception to this, which is explained later).
The tax deferred amount is effectively a distribution in excess of the security holder's share of the taxable income of the trust. Although tax does not usually have to be paid on this amount in the current period, the ATO does eventually catch up with you - there are later CGT implications if and when you sell your units.
As mentioned, CGT is applied to shares when they are sold for a price higher than they were acquired (after acquisition and disposal costs). Similar rules apply to REITs, but their acquisition cost (referred to as the cost base), unlike ordinary shares, can change through time. That is because the "tax deferred" components of the distributions referred to are progressively applied to reduce the cost base of the investment.
A lower cost base means more CGT is payable when you come to sell (that is how the ATO eventually catches up with you). But in keeping with the "hold forever principle", if you don't sell, you don't pay the tax.
Now for the circumstances, in which the ATO does ask you to pay tax, in the current period, on the tax deferred part of the distribution. As stated, tax deferred amounts are applied to reduce the cost base of the investment, and so increase the unit holder's CGT liability if and when the units are ultimately sold. It's an unusual event, but if the accumulated tax deferred amounts reduce the cost base to zero, any excess is treated as a capital gain in the current period.
The most important thing
And so to the question, is it better to buy shares (which carry franking credits) or REITs (which carry a "tax free" component)? My answer must be: It depends…
The comparison involves many variables. It depends on the REIT you are considering and the structure of the cash flows that make up its distribution. It depends on the dividends and franking credits associated with the company you are comparing it to. It depends on the tax structure in which you are holding your investments. And it depends on when you plan to sell, or in fact whether you plan to sell at all.
That is not to detract from the importance of tax considerations. They are important to investors. Just ask any Australian basking in the tax oasis referred to as superannuation. But comparisons between investments based purely on tax considerations can become complicated by a minefield of variables and specific circumstances.
And more so than tax considerations, the most important thing to ask yourself when investing is: First and foremost, is it a good investment?
About the author
Michael Kemp is chief analyst at The Barefoot Blueprint, a leading wealth-management tool.
ASX Glossary helps new investors comprehend investment terms and learn the language of the sharemarket.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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