For investors who want to compound the high yields available on some property funds and trusts by reinvesting their dividends, there are a few differences between the two asset classes which they need to consider before starting out.

Open-ended property funds usually give shareholders the option to automatically reinvest their dividends by offering accumulation units.

REITs (real estate investment trusts) on the other hand are required by law to pay out 90% or more of their tax-exempt earnings as well as 100% of any property income distributions received from other REITs rather than reinvest them, making the investor do the leg work.

However, there are other pros and cons to each model, not least liquidity, costs and tax considerations, so Shares has prepared a handy guide.

FUNDS AND ETFS

When we refer to funds in this article, we are talking about open-ended investment vehicles whose assets can rise and fall depending on capital flows as opposed to closed-end funds such as investment trusts where capital is considered ‘permanent’.

This makes a big difference when looking at property as an asset class, as investors who were exposed to the sector during the financial crisis and more recently during the coronavirus crisis will remember only too well.

In both instances, dealing in funds run by big insurance firms like Aviva (AV.) and Legal & General (LGEN) aimed at the retail market had to be suspended to stop investors pulling their money out because these funds couldn’t quickly liquidate any of their assets to meet daily redemption requests.

During the coronavirus crisis, even funds with monthly or quarterly redemptions aimed at institutional investors had to close their doors due to lack of liquidity.

ETFs or exchange-traded funds tend to be more liquid than open-ended funds and typically have lower fees, but those that invest in fixed assets like property are less liquid than those which invest in stocks or bonds.

With those caveats in mind, investors who want to compound their dividends from property funds can buy what are known as accumulation units as opposed to income units. These can be found with both open-ended funds and some ETFs.

As the name suggests, dividends are accumulated and reinvested in the fund rather than being distributed.

However, unless the units are held in a tax wrapper such as an ISA or a SIPP (self-invested personal pension), the reinvested dividends are considered to be a ‘notional distribution’ according to HMRC and are subject to the level of same income tax as the income units.

As a result, once reinvested dividends exceed your tax-free dividend income allowance of £2,000 you will have to start paying income tax.

Also, unless the units are held in a tax wrapper such as an ISA or SIPP, when you come to sell them you will pay capital gains tax on any increase in value which exceeds your annual allowance, which is £12,300 for the current tax year.

Capital gains tax is payable on the value of the accumulation units when they’re sold, minus the original investment and any income accumulated.

Therefore, holders of accumulation units should keep a record of all their ‘notional distributions’ so that when they come to sell, they can work out how much of the sale proceeds are capital gains and are liable for tax.

The same holds for ETFs which pay dividends, regardless of whether you physically receive income, or it is reinvested in the fund.

REINVESTING VIA REITS

While real estate investment trusts must pay out the vast majority of their profits as dividends, you can reinvest that money as long as your custodian or platform allows it.

Most platforms offer the option to reinvest dividends, although there is typically a small fee for doing so.

For example, AJ Bell charges £1.50 per deal, so if your regular dividend is £100, for example, then the cost of reinvestment is small. If your dividend is only £5, however, you must question if you want to spend 30% of your dividend money on fees.

Dividends from REITs are known as a PID or ‘property income distribution’ and are normally paid after the trust has deducted withholding tax at the basic rate of income tax (currently 20%) which it pays to HMRC on behalf of shareholders.

Trusts can also offer non-PID dividends from taxed income on activities other than lending, and they can issue ‘scrip’ dividends or ‘bonus’ shares which allows the company to keep hold of its cash and shareholders to increase their stake without any additional cost.

Scrip dividends are treated like any other kind of investment income so for tax purposes, unless the trust is in a tax wrapper, you need to make a note of the ‘cash equivalent’ which you would have received if you hadn’t been given new shares.

DISCLAIMER: AJ Bell referenced in this article is the owner and publisher of Shares magazine. The author (Ian Conway) and editor (Daniel Coatsworth) own shares in AJ Bell.

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