Soften the tax bite with REITs
It’s that time of year again — tax time, that is. Like many Canadians, you’re probably dismayed at the big chunk governments take out of your income and are searching for ways to soften the tax bite.
If that’s the case, take a look at real estate investment trusts (REITs). They’re a specialized type of income trust that offers very good cash flow plus a bonus of deferred taxes if held outside a registered plan.
As an investment, REITs may the answer to your income and tax needs, but you should look at the options carefully before you invest. To help you make the right decision, here’s a quick summary of everything you need to know about REITs.
What they are. REITs invest in commercial real estate. Originally, most REIT portfolios were diversified. Now, they tend to be more focused: RioCan (REI.UN), the largest Canadian REIT, specializes in shopping malls; Retirement Residences (RRR.UN) zeroes in on retirement homes; Legacy (LGY.UN) owns hotels. And so it goes.
How they work. REITs collect rents on the properties they own and distribute the profits to unitholders on a tax-advantaged basis. The more efficie the REIT management, the better the cash flow.
The tax story. The tax breaks originate with the fact that depreciation on properties owned by a REIT is passed through to unitholders of the trust. As a result, a portion of the cash flow is received on a tax-deferred basis.
This is a tax deferment, not a tax exemption. Eventually, Canada Customs and Revenue (CCRA) will get its share. That’s because you must deduct the amount of tax-deferred revenue you receive each year from the price you originally paid for your units to arrive at what’s known as the adjusted cost base (ACB).
For example, if you pay $10 for your shares and receive $0.50 in tax-deferred distributions in the first year, your ACB will be $9.50 ($10 – $0.50 = $9.50). If you received the same amount on a tax-deferred basis in the second year, your ACB would drop to $9. When you sell your units, the ACB will be used to calculate your capital gains tax liability. So if you have an ACB of $8 and you sell at the original price of $10, you will have a capital gain of $2, of which half is taxable. If you never sell, your tax deferment continues until you die and your estate disposes of them.
Next page: Market risks
The market risk. REITs are highly interest-rate sensitive. One of the reasons that they have performed so well as a group in the past few years is because of the low interest rate environment we’re experiencing.
There are two reasons for this rate sensitivity. First, lower rates mean reduced costs for the REITs because existing mortgages may be refinanced and new ones obtained at much more attractive levels. Second, as rates fall, REIT yields can drift lower and still look very attractive to investors. That phenomenon will push the share price higher. When rates rise, we see the opposite effect.
REITs in an RRSP/RRIF. Canadian REITs are normally fully eligible for registered plans. Some people have purchased them for RRIFs because of their attractive yields. The tax benefits are lost if you do this, but the good news is that you won’t have to worry about the ACB.
There are many REITs from which to choose but, if you would like to buy a basket of them, take a look at a new product that was listed on the Toronto Stock Exchange for the first time last fall under the symbol XRE. It has the awkward name of iUnits S&P/TSX Canadian REIT Index Fund, or iREITS for short.
When you buy these units, you’re investing in a basket of shares in the 12 REITs that make up the S&P/TSX Canadian REIT Index. The units pay quarterly distributions and yield around 8.5 per cent. A portion of the distributions will be tax-deferred, based on a weighted average of the payments made by the underlying REITs.
These units are particularly well suited for the non-registered portfolios of income-oriented investors. Discuss them with a financial adviser before making a decision.
Gordon Pape is a financial author and leading expert on mutual funds. The opinions expressed in this article are those of the writer and should not be understood as offering advice. Information is of a general nature and may not be appropriate for any single individual.