Calculate your adjusted cost base

Anyone who invests in income trusts, either directly or through mutual funds, must understand the concept of the adjusted cost base (ACB) and the tax implications that flow from it.

Many of these securities make payments which are classified as “return of capital” for tax purposes. In a few cases, 100% of the payments fall into this tax category (we have a specific recommendation this month).

Any distributions that are deemed to be return of capital are not taxed in the year they are received. However, that doesn’t mean they are tax-free. The term “tax-deferred” is more correct.

Whenever you receive a return of capital distribution, you must deduct that amount from the price you originally paid for your units, to arrive at an adjusted cost base. This will change from year to year as more such payments are received.

For example, suppose you pay $10 a unit for an income trust on the initial public offering. In the first year, you receive 70c in return of capital distributions. Your ACB at the end of that time is $9.30 ($10 minus 70c).

In the second year, distributions are increased (it’s a good fund) and t return of capital portion rises to 80c. Now your ACB is $8.50 ($9.30 minus 80c). This continues for as long as you own your units.

When the time comes to sell, subtract the current ACB from the proceeds of the sale to determine your capital gain. Let’s assume that in this case you sold at the end of year two for $10, the same price you originally paid. Deducting your current ACB of $8.50 leaves you with a capital gain of $1.50 per unit. Half of that is taxable, so you must pay tax at your marginal rate on 75c per share.

That’s a pretty good deal. You received $1.50 in payments but you end up paying tax on only half that amount. Of course, the longer you hold your units, the longer you can defer the tax (at least until the ACB falls to zero). Just remember that at some point you, or your estate, will have to pay the tax people some of that money. The free lunch won’t last forever.