If you invest in a real estate investment trust (REIT) like British Land (BLND), Assura (AGR) or Derwent London (DLN) you might have noticed that some or all of your dividends are paid as ‘property income distribution’ (PID) dividends.

The key difference between PID and ‘normal’ dividends is the way they’re taxed. This has important implications for where you decide to hold your investments.

Why do PIDs exist?

PID dividends have been around since 2007 when the REIT regime was introduced in the UK.

A REIT is a special type of status conferred upon certain commercial property companies. It allows investors to invest in real estate and be treated for tax purposes as if they owned the property directly.

To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment.

Ion Fletcher, director of policy (finance) at the British Property Federation, says if the REIT rules didn’t exist investors would suffer double tax: once because the company would pay corporation tax and twice because you’d then pay tax on the dividends.

A company with REIT status isn’t subject to corporation tax. In return, HMRC demands that REITs distribute at least 90% of their property income to shareholders every year as PID dividends. The REIT must withhold basic rate income tax of 20% on these payments.

‘In this way, HMRC still collects tax from REITs, although it is effectively paid by investors rather than by the REIT,’ explains Fletcher.

Mix and match

Some REITs, such as Assura, give you the option to receive your PID as either a cash dividend or a stock dividend.

Instead of providing you with income, a stock dividend effectively increases the amount of shares you own in the company.

REITs can also issue normal dividends which are subject to the normal tax rules.

British Land, for example, says dividends can be entirely PID, entirely non-PID or a combination of the two. The board decides the most appropriate make-up on a dividend-by-dividend basis.

At least 90% of profit from British Land’s property rental business has to be distributed as PID dividends. Its other business activities are the source of income for normal dividends.

Derwent London announced a final dividend of 38.5p in its 2016 results, of which 32.7p will be paid as a PID and the balance of 5.8p as a conventional dividend.

How are they taxed?

PIDs are taxed as property rental income. You have to declare it as such on your tax return in the same way as if you received rent from a buy-to-let property.

When you receive a PID you’ll already have paid withholding tax of 20%. If the REIT paid out £100, you’ll receive £80 and HMRC will get £20.

If you’re a basic rate taxpayer you won’t have to pay any more tax when you fill in your tax return. Higher rate taxpayers are taxed at 40%, so using the above example they’d need to pay an additional £20 to HMRC.

Because PIDs are taxed as property rental income, they can’t form part of your annual dividend allowance.

Normal dividends benefit from a £5,000 dividend allowance – you can receive dividend income of £5,000 and you won’t have to pay any tax on it.

The importance of tax wrappers

The only way to ensure you don’t pay tax on your PIDs is to hold your REITs in a tax wrapper, such as an ISA or pension. If you do this, the PID will be paid gross – i.e. without the withholding tax deducted.

Stockbroker AJ Bell Youinvest says if you own accumulation units it’s not possible to receive the distribution gross. Instead, the tax equivalent is reinvested into the fund and additional units will be credited to you. It is all done automatically by the platform.

Which tax regime is more beneficial?

Kersten Muller, a partner in Grant Thornton’s real estate tax team, says if you’re investing through ISAs and pensions, REITs are a lot more tax advantageous than non-REITs.

This is because non-REITs have to pay corporation tax of 19% on their profit, so the dividends are being paid from a smaller pot.

‘If you hold a REIT in an ISA it is completely tax-free. The REIT is exempt from corporation tax and the investor doesn’t have to pay tax on dividends because of the ISA wrapper,’ says Muller.

If REITs and non-REITs are held outside of an ISA or pension such as in a dealing account, a basic rate taxpayer would either be affected by the 19% corporation tax levied on a non-REIT or the 20% withholding tax levied on a REIT PID dividend.

Higher rate taxpayers would be affected by the same 19% corporation tax paid by non-REITs and would have to pay 40% withholding tax on the REIT PID dividend.

Don’t forget your dividend allowance

The tax you pay on non-PID dividends will be higher if you’ve breached your annual dividend allowance. Basic rate taxpayers will be taxed at 7.5% and higher rate taxpayers at 32.5% on any dividend income above £5,000.

If you’re likely to exceed your annual ISA allowance (currently £20,000) and your dividend allowance, you can analyse the various tax charges to determine the most tax-efficient place in which to hold investments.

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