Q&A: Income trusts and taxes

Question: I enjoy looking after my stock portfolio and among my holdings are several good quality income trusts. Lately, I have become pretty well convinced that holding these trusts within my stock portfolio is not as beneficial as it looked at first glance because all but one of them of them generate “yield” which is classified as either “Interest” or “Other Income”, both of which are taxed as interest.

My work pension together with my Canada pension, OAS, and dividends generated from my stock portfolio put me into the $65,000 bracket so far as my taxable income is concerned. I have an RRSP which will begin kicking out to me an additional $9,000 a year this coming spring.

Am I correct that, other than the relatively few among the good quality trusts which generate either a significant “true” dividend or “Return of Capital”, income trusts held in an unsheltered account are not tax efficient for someone with healthy work and government pensions which put him into my tax bracket, because so much of the benefit is lost due to the yield being taxed as interest? – M.Q.

Gordon Pape answers: Yu’re both right and wrong, but you have hit on a common misconception. Many investors seem to believe that all trusts come with built-in tax benefits. That is definitely not the case.

That said, there are a lot of trusts that offer good tax advantages. You might want to consider making some changes in your portfolio to benefit from them. I suggest you start with the REITs. Virtually all of them offer good tax breaks in the form of tax-deferred return of capital. For example, look at the country’s largest REIT, RioCan. In 2005, about 37 per cent of the distributions qualified as return of capital with another 13 per cent considered capital gains. So investors paid the full tax rate on only half the amount they received.

You can also find some business trusts that are tax-friendly, such as Primary Energy Recycling Corporation. About 75 per cent of its payments qualify for the dividend tax credit.

Some of the closed-end funds and mutual funds that specialize in income trusts are also tax-efficient. To cite one example, only 50 per cent of this year’s distributions from the Citadel HYTES Fund are fully taxable. Do some research to identify others that meet your needs.

Note that I am not recommending the purchase of any of these securities. I am only using them as examples. Consult a financial advisor for specific guidance.

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