Real Estate Income Trusts, or REITs for short, are companies that own or finance income-producing real estate. They receive special tax considerations and tend to have a higher distribution yield than corporations.
Real estate assets can range from shopping malls, to apartment buildings, to office properties, or a mixed of the different assets. Due to the REIT structure and tax code, REIT taxation for investors in Canada differs from dividends and warrant a good understanding by individual investors. See below for the Canadian break down by sub-industries.
While REITs are meant to be tax-efficient businesses, their distributions is not a tax-efficient in the way that dividends are from corporations.
Before we dive into the tax impact of holding a REIT in a non-registered account, you need to understand the difference between dividends and distributions.
If you look at the information provided on a REIT website such as RioCan, you can see that they mention distribution and not dividend. It simply means that the company’s distribution to investors is not considered an eligible dividend from a tax perspective.
In fact, dividends are reported on a T5 form while distributions are reported on a T3 form (see below). It is possible to receive some dividends from a REIT and if so, it will be included as one of the source of income and also be reported on the T3 with the gross-up information needed.
RioCan clearly outlines the ratios of the following income sources on their site. As you can see, there can be up to 6 different sources below.
In a tax-free account, such as TFSA, RRSP/RRIF or RESP, holding a REIT investment is not a concern since you don’t have to pay any taxes but in a non-registered account, it has an implication and considerations.
Not only because you declare the distribution as income on your taxes but because there can also be a return of capital (ROC) and that impacts your accounting. Note that ROC from REITs is the most tax efficient payout as the distribution is converted into a potential capital gain to be paid later at the time of disposition.
ROC, however, makes your accounting so much harder. It’s better to hold in your TFSA or RRSP account.
When choosing the best Canadian REIT, if you plan on holding it in a non-registered account, you need to compare the net income from the REIT you have in mind with a good high yield stock such as Bell Canada. The tax impact can make both investments be the same in the end.
REIT Taxation (in Canada)
Income Tax Treatment on Investment AccountsIncome tax on REITs is actually pretty simple to understand, however, the tracking of the details year after year is where the challenge is.
The reduction in adjusted cost base (ACB) is what creates a tracking challenge. In the RioCan example above, you can see a pretty large ratio of return of capital (ROC – another name for the adjusted ACB) and that changes the cost of your investment.
You need to adjust the cost of your holdings every time you receive the T3. You, therefore, need to be diligent with your tracking as you will have to report capital gains at a later time. It’s even possible that the cost of the share ends up at $0 if you hold the REIT for long enough.
It’s important to note that none of the tax considerations below apply when you hold REIT investments in a tax-sheltered account. You may also need to consider that withdrawal from an RRSP are treated as income and your marginal tax rate will apply.
REIT Tax Breakdown
Other Income: This amount represents the revenue you are getting from the REIT as part of their operating business. Think of this income as the rental revenue from the holdings. This income is taxed at your marginal tax rate just like interest would be taxed.
Capital Gains: The capital gains reported is taxed at half your marginal tax rate. It is also said that you are taxed on 50% of the capital gains at your marginal tax rate.
Foreign Non-Business Income: When a REIT holds US or foreign properties, the foreign revenue is reported as Foreign Non-Business Income and is taxed at your marginal tax rate. It usually represents the rental income from the foreign holdings.
Return of Capital: This amount is the company giving you your money back. There is no immediate tax to pay on it as it simply reduces the cost of the share. It requires a good stock tracking system. ROC is referred to as a reduction in adjusted cost base (or ACB). For example, if you paid a REIT share $10 and the REIT has a ROC of $0.50 per share, your new cost is $9.50 per shares. As you can see in the RioCan distribution above, the ROC ratio of a distribution can be significant.
This is the reason why I don’t hold REITs in a non-registered account. The tracking is a lot of work even though I am well set up to track my investment portfolio. However, it can be more efficient from a tax perspective since capital gains is one of the more favorable tax treatment. You simply need to decide on putting the effort to track all of the transactions from DRIP and ROC when it’s provided to you.
Dividend & Distribution Tax Summary
|Canadian Dividends||Preferred Canadian Dividend Tax Rate||No Taxes||No Taxes||No Taxes||TSE:RY|
|Canadian Distributions (REITs, Income Trusts)||Normal income and Capital Gains taxes can apply.||No Taxes||No Taxes||No Taxes||TSE:REI.UN|
|US Dividends||15% Withheld – Foreign Tax Credit can be claimed. Income tax rate applies.||15% Withheld – No Foreign Tax Credit||No Taxes||15% Withheld – No Foreign Tax Credit||NYSE:JNJ|
|US Distributions (MLPs)||39.6% Withheld – Foreign Tax Credit can be claimed. Income tax rate applies.||39.6% Withheld – No Foreign Tax Credit||39.6% Withheld – No Foreign Tax Credit||39.6% Withheld – No Foreign Tax Credit||NYSE:MMP|