REIT Taxation

The following post is written by Brian So, a financial advisor and blogger at www.aafsinsurance.com.

Introduction to REITs

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REITs, also known as Real Estate Investment Trusts, are publicly listed companies that own income-producing real estate. Their assets include hotels, shopping malls, office buildings and apartments. Originally created in 1960 by the United States, REITs have spread worldwide and have a strong presence in Canada as well. In order to qualify as a REIT (in Canada), at least 95% of its income must come from real estate assets, and at least 80% of its properties must be located in Canada.

The popularity of REITs stems from the fact that they allow ordinary individual investors a means of participating in a diversified portfolio of real estate traded on stock exchanges. The returns are also tax-efficient for investors, as shown later. From the perspective of the companies, REITs are tax-efficient in that they are allowed to distribute 75-95% of their taxable income to their unit holders. As long as their income is distributed to their unit holders, the REITs themselves will not be subject to tax.

Taxation of REITs

Distributions from a REIT can be made monthly or quarterly. They are not classified as dividends, so they aren’t subject to the gross-up and dividend tax credit. The distributions actually consist of several types of return, which includes: other income, capital gains, foreign non-business income and return of capital.

Other income and foreign non-business income are taxed at your marginal tax rate. Capital gains are taxed at half your marginal tax rate. These are all straightforward and reflect tax rules in place for similar investments.

Return of capital (ROC), on the other hand, is trickier from a tax perspective. Distributions allocated to ROC reduce your adjusted cost base (ACB). When you eventually sell the units, the ACB will be subtracted from the proceeds of distribution to arrive at your capital gain/loss. Once your ACB reaches zero, any ROC distributed will give rise to a capital gain. It’s essential to note that capital gain distributions are different from a capital gain that results from selling the units. The former takes place monthly and is a result of the REIT disposing of its assets at a gain, while the latter is triggered only when you personally sell the units.

Consider this example. Your ACB is $200 and the REIT pays a distribution of $800, consisting of $100 other income, $400 capital gain and $300 ROC. The ROC will reduce the ACB to -$100, so you will receive an immediate capital gain of $100. Half of the capital gain, or $50, will be taxable. The ACB will then be adjusted to zero. Half the capital gain distribution ($200) will be taxable, along with the entire income distributed ($100). The total income you must report is $350.

Most of the time, your ACB will be positive and any ROC distributed to you won’t be taxable immediately. In a way, you are receiving income but deferring tax on it until a later point in time. Here is an example to illustrate the tax-deferral benefit of REITs. Your ACB is $500 and the REIT pays a distribution of $100 per year for 5 years, of which $50 is income and $50 is return of capital. Of the $100 annual distribution, you will only be taxed on half of it. The other half will reduce your ACB until the fifth year when your ACB is $250. When you sell the units after the fifth year for $1,000, you’ll have a capital gain of $750 ($1,000-$250). Essentially, you’ve deferred paying any tax on the return of capital until year 5.

The fact that the ROC reduces your ACB and isn’t taxable unless your ACB is negative is attractive to unitholders. It’s a type of tax-deferred return, similar to how the tax liability in a RRSP is deferred until withdrawal. The downside is that you will have to keep track of your ACB manually for when you eventually sell the units. Canadian unitholders will receive a T3 from the REIT or your broker which breaks down the amount of other income, capital gain and return of capital. The T3 will help you keep track of your ACB.

REITs in Registered and Non-Registered Accounts

Canadians can either buy a REIT directly, or hold a diversified portfolio of REITs in an ETF or mutual fund. REITs are qualified investments in non-registered and registered plans, such as the RRSP and TFSA. The section above described the taxation of REITs in a non-registered account. In a RRSP, distributions will not be taxed until withdrawal, at which point the entire withdrawal will be treated as income and taxed at your marginal tax rate. In a TFSA, neither distributions nor capital appreciation will be taxable. You will be able to withdraw your entire contribution tax-free.

If you hold US or other foreign REITs in your portfolio, withholding tax will be applied to some of the distributions. Generally, you can recover this withheld amount in a non-registered account by claiming the foreign tax credit. However, the withholding tax is not waived in a RRSP or TFSA. As a result, the withheld amount will be lost forever. Withholding tax is just one of the factors to consider when deciding to allocate REITs in registered or non-registered accounts. You also have to consider about your marginal tax rate and the proportion of each type of return from the distributions.

At a time when everybody is looking for yield, investors will find the distributions of REITs appealing. If you are interested in REITs or already hold them in your portfolio, this post should clarify how they are treated from a tax standpoint. Please seek a tax professional and financial advisor if you require assistance with your current situation.


Brian So is a financial advisor, future CFP and blogger at http://aafsinsurance.com. His areas of expertise include retirement planning, tax savings and insurance advice. If you want to hear his thoughts about the world of personal finance, follow him on Twitter.

25 Responses to “REIT Taxation”

  1. Dividend Ninja

    Mar 17. 2014

    Excellent post Brian! You are really helping investors understand the tax basics here – clear and well laid out.

    Thank you!

    Cheers
    Avrom

    • Brian So

      Mar 17. 2014

      Thanks Avrom! REITs have been gaining popularity in recent years in this new norm of low interest rates. I hope your readers were able to learn the basics of REIT taxation.

  2. Shawn Carroll

    Mar 17. 2014

    Thanks for the great article about taxation. This will definitely help me look at each REIT to see exactly how their returns are distributed so I can try to be as tax efficient as possible.

    • Brian So

      Mar 18. 2014

      Glad you enjoyed it. You can generally find more information about a REIT’s distributions on their website under ‘Investor Relations’.

  3. Steve

    Mar 18. 2014

    A wonderful article that clearly explains the tax implications of holding REITs in various accounts – thanks very much Brian!

    Also, a big “Shout Out” to Avrom for posting this on the Ninja blog.

    Keep up the great work!

  4. My Own Advisor

    Mar 18. 2014

    Nice post Brian! Lots of details!

    I hold my REITs in registered accounts only, to purposely avoid the taxation mess. I have enough to deal with the the DTC and dividend-paying stocks. :)

    Mark

    • Brian So

      Mar 18. 2014

      Registered accounts are one way to avoid tax headaches :)

      • Don G

        Mar 21. 2014

        Hi Brian

        I saw your article through my MOA link. Excellent stuff.

        I’d just like to add that I do my own taxes and that I don’t think it is that big a deal to keep track of the ROC and ACB. I have 5 REITs and I intentionally keep 3 of them with a high ROC% in non-registered accounts because I like the tax deferral. Also, if I ever do sell them, then the amount from the ROC will be treated as a capital gain instead of straight income as it would coming out of an RRSP.

        Ciao

        • Brian So

          Mar 21. 2014

          Thanks for the comment Don.

          Depending on the makeup of your portfolio, it often does make sense to leave REITs outside a registered account, for the reason you mentioned. Every situation is different though. For instance, if you are just starting out investing and have unused TFSA room, it may be better to put REITs in there, to avoid taxes altogether.

          I like your strategy though. Do you find that the proportion of the ROC of the REITs you hold stay consistent year after year?

          • Don G

            Mar 21. 2014

            Hey Brian

            Thanks for commenting back so quickly.

            I’m 61 and retired and live off dividend/distribution income so more cash with less immediate taxes is one of my goals.

            The ROC does vary a bit for some of my REITs from year to year but not significantly. Right now, my 3 non-registered REITs are TN.UN at 100% ROC, AX,UN at 88%, and DIR.UN at 65%. I sort of have a minimum cutoff of around 62% to match the dividend gross up and sort of trying to balance net taxable income.

            I have quite a bit of non-registered dividend income and so am trying to position myself to eventually avoid OAS clawback. Both my wife and I have sizeable RRSPs so I’m trying to move a certain amount out before RRIF conversion time. All in all, quite complicated but I think I’ve worked it out and certain REITs in the non-registered accounts is part of it.

            I totally agree that everyone’s situation is different which is why I commented originally as MOA had said that REITs are always better in a registered account and I disagreed with that.

            Thanks again.

  5. Dividend Ninja

    Mar 18. 2014

    Hi everyone,

    I had a couple of emails from readers. As Mark points out, the best place to hold Canadian REITs is in a registered account: RRSP or TFSA. This is the preferred location for REITs, with the higher yield, and treatment of distributions as income.

    If you are holding U.S. REITs then these need to be held outside of your TFSA or RRSP, in a non-registered account…

    Cheers
    DN

    • John

      Mar 21. 2014

      It’s probably still better to hold US REITs in a registered account. When held in a non-registered account the distributions will be taxed as income at your marginal rate. At least in a registered account the distributions will be sheltered although as mentioned the 15% withholding tax will be non-recoverable.

      • Brian So

        Mar 24. 2014

        Good point John. In some cases it’s better to keep US REITs in registered accounts and bite the bullet knowing withholding tax is unrecoverable. You’ll lose some of the return, but can still delay taxes until withdrawal.

  6. HarveyM

    Mar 22. 2014

    Hi,
    I own ZRE in my RRSP as some REIT diversification is useful so they say. Not sure what percentage of portfolio is appropriate? Moving into retirement soon I’m thinking of increasing that. Since I’m in healthcare I’m looking at Northwest Healthcare Property REIT. Mostly doctor/dentist/medical lab/x-ray space. I’m thinking that those types don’t move around alot.

    You have a great site :)!
    h.

    • Brian So

      Mar 24. 2014

      Hi Harvey, thanks for commenting.

      REITs are a great asset class with which to diversify your portfolio. Although REITs have characteristics of fixed income, they are still classified as equity and experience similar levels of volatility as other sectors. I would suggest looking at your financial goals, how much income you require, the makeup of the rest of your portfolio and your risk tolerance to determine what percentage of your portfolio should be invested in REITs.

  7. Kathy

    Apr 04. 2014

    REITs are a way of investing in real estate for those like me who do not want to own individual rental properties. I’ve always thought real estate to be a good investment but I don’t want the hassle of managing properties, tenants etc. So we’ve included one or two REITs in our portfolio with nice success so far. Thanks for a good discussion.

    • Dividend Ninja

      Apr 04. 2014

      Hi Kathy,
      You’re not alone on that line of thought! There are many wealthy investors who would rather own a REIT, or group of REITs, than take on the headaches of owning real-estate directly. It makes sense, a great yield and potential for capital appreciation as well.
      Cheers
      DN

    • Brian So

      Apr 04. 2014

      Thanks for the comment Kathy. Besides not having the hassle of managing real estate property, REITs also provide much more diversification.

  8. Daniel

    Apr 05. 2014

    Nice article. Just to clarify – if I own a US-listed REIT ETF in my RRSP (say, VNQ) will I still have to pay a yearly withholding tax?

    • Brian So

      Apr 07. 2014

      Hi Daniel, glad you enjoyed it.

      There will be tax withheld with a US-listed REIT ETF in your RRSP. They hold both US and foreign companies. If you remember from my post on withholding tax, there are two levels of withholding tax: one from dividends paid by the international company to the US ETF, and the second from the US ETF to you. Tax will be withheld from the first level, but not the second if you hold the ETF in your RRSP, since US withholding tax is waived for a retirement specific account.

      Hope that helps.

  9. Nice article that clearly explains the tax consequences of holding REITs in different accounts – thanks.

  10. Mike

    Jun 21. 2014

    Thanks for sharing your expertise Brian.

    I was wondering if you could provide a little bit of clarity on a point.

    If I buy a US REIT inside my RRSP will I have to pay US withholding taxes?

    I am confused because I own US stocks (non REIT stocks) like Coca-Cola which pay me the full dividend without any withholding taxes when held in my RRSP. Why would this be any different for a US REIT dividend?

  11. Bernie

    Aug 05. 2014

    Thanks for your article. I would like to point out that I hold 3 U.S. REITs in my RRSP (OHI, NHI & LTC). There is no withholding taxes on distributions of these three or, for that matter, on STWD which I held in the past.

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