Maximizing the REIT tax advantage

By Gena Katz | April 8, 2011 | Last updated on September 15, 2023
3 min read

It’s 2011 and the new distributions tax relating to flow-through entities, including income trusts that existed on October 31, 2006, now applies.

The effect of the new tax is to treat these entities like corporations and eliminate their tax advantage. In anticipation of the new tax, many income trusts converted to corporations over the past few years. There is, however, an important exception to the new rules—Real Estate Investment Trusts (REITs), but only if they meet certain conditions.

  • They cannot hold non-portfolio property other than real property and securities of entities engaged in certain real estate activities;
  • The fair market value of real estate, cash and certain debt investments must be at least 75% of the trust’s equity value;
  • At least 95% of trust revenue must come from dividends, interest, rents, royalties and taxable gains from the sale of real properties;
  • At least 75% of the revenue must come from rent, mortgages or capital gains from real properties.

Real estate does have a place in a well-diversified investment portfolio. And if you have clients who are interested in increasing their exposure to real estate, REITs are worth some consideration.

REITs hold, maintain, improve, lease or manage a variety of commercial, residential or industrial properties. The trust units are publicly traded and there is no tax payable at the trust level if all income is distributed to unitholders annually. Unitholders are taxed on the income and capital gains are distributed to them.

REIT distributions often exceed trust income (deductions such as capital cost allowance reduce income without reducing funds available for distribution). Distributions in excess of income and capital gains represent a return of capital and are not taxable. But they do reduce the cost base of the trust units, which translates into a larger capital gain on sale or redemption of the units. It is generally the investor’s responsibility to maintain records of the cost base.

REITs have advantages over direct real estate investment or ownership through shares of a real estate corporation. They provide the smaller investor with an opportunity to diversify among various real estate classes and locations—an opportunity that is not available with limited funds—and to gain access to the commercial real estate market, which is usually open only to institutional investors.

Also, because REITs are publicly traded, they are a more liquid form of real estate investment than direct ownership. REITs are qualified investments for RRSPs, RRIFs and TFSAs.

The fact that they act as flow-through vehicles, with no tax at the trust level, makes them particularly attractive for tax-deferred plans. The plans would receive pre-tax income, compared with ownership of real estate corporation shares that provide after-tax dividends.

But there are a few disadvantages.

With a mutual fund structure, losses cannot be flowed through to investors (an advantage that would be had in direct ownership). These losses can, however, reduce trust income in a future year.

In addition, the net rental income that flows through to the unitholder loses its character; it is considered trust income and not rental income and therefore it does not form part of earned income for RRSP purposes.

REITs generally report an attractive annual yield compared with other investments that pay interest and dividends. But don’t forget to consider that some of this reported yield may include a return of capital and, as a result, the comparison is not a fair one.

Finally, keep in mind that, like other investments, REITs should not be evaluated on tax merits alone. Investors must consider risk, cash flow, underlying assets and quality of management.

Gena Katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge.

Gena Katz