Keep more of what you make with REITsMarch 17, 2020
Investing in real estate is a great way to develop wealth and improve your cash flow. In addition to the benefits of receiving monthly rental income, you can also potentially realize some significant tax benefits. By taking advantage of the tax benefits of investing in real estate, you can keep more of what you make.
It’s important to know that not all investment products are created equal from a tax perspective. Many standard investment products - such as GICs, bonds, stocks - require the payment of taxes on the income and/or dividends received by the investor on an annual basis . On the other hand, real estate investment trusts (REITs) can be highly tax efficient, and under normal circumstances, an investor will pay lower taxes and defer most if not all tax payments until the investor sells the REIT.
Typical Cashflow Investments
Normally, when a Canadian investor wants an income stream, they typically buy a bond to receive the monthly interest payments, or they invest in common/preferred stocks to receive the dividend payments. In both cases, however, the disbursements from these investments are taxable in the year they are received, which impacts their annual cashflow and hence disposable income.
For example, an investor wants to receive an income stream of $10,000 per year. If the investor has a 45% marginal tax rate, their actual after-tax cashflow from a common and/or preferred stock investments would only be $7,147 per year and their after-tax cashflow from a GICs and/or bond and/or MIC investments would only be $5,500.
Tax Efficient Cashflow Investments
One of the primary advantages of investing in a REIT is the tax treatment afforded to the REIT’s distributions. A REIT is allowed certain non-cash deductions for tax purposes, such as capital cost allowance, which typically lowers the REIT’s taxable income without reducing the cash available for distributions. This permits the REIT to make cash distributions to the investor in excess of its taxable income. Any distribution in excess of the REIT’s taxable net income represents return of capital (ROC) to the investor, and unlike interest, dividends and capital gains, income classified as ROC is not taxable in the year it is received. Consequently, as depicted in Graph 1 the REIT investor would keep 100% of the $10,000 they received in distributions from the REIT.
It should be noted that ROC distributions will lower the investor’s adjusted cost base (ACB) on their REIT investment, which may increase the amount of capital gains related taxes they will be required to pay once they dispose of their REIT investment.
In summary, an investment in a tax efficient REIT generates a high after-tax cashflow, and therefore an investor can initially put a lower amount into the REIT to generate the same level of annual after-tax cashflow as would be required if they invested in a GICs/bonds/MICs or common/ preferred stocks.
Also, when they finally dispose of their REIT investment, the investor would likely have paid less in total taxes over the life of the REIT investment than if they had held a comparable yielding GICs/bonds/MICs or common/preferred stocks for the same length of time.