On October 31, 2006, the federal government announced that most stock exchange listed income trusts would lose their tax advantage over corporations. Although existing income trusts keep their tax advantaged status until January 1, 2011, the initial shock of the announcement wiped twenty-five billion dollars off the market capital of income trusts. The government decided to stem the flow of business conversions from corporations to income trusts because it believed income trusts had a negative effect on the economy since they paid no tax and distributed most of their profits rather than reinvesting profits to grow their businesses. Fortunately, the government has preserved the tax advantage for real estate investment trusts (REITs), which also enjoy preferential treatment in other countries such as the United States.
The REIT tax advantage works like this: when a REIT makes a distribution to its unitholders, it can deduct that distribution in calculating its taxable income. This means that if a REIT distributes at least as much as its taxable income for a tax year, it pays no tax for that year. In contrast, a corporation is not able to deduct dividends it pays to its shareholders.
Only certain types of REITs qualify for this tax advantage. REITs that earn income strictly from passive real estate activities, such as rental income or mortgage interest, qualify. REITs that earn income from land development or from hotels or nursing homes don’t qualify. For this reason, some established REITs are spinning out their non-qualifying business lines before January 1, 2011 so that they will continue to qualify for the tax advantage.
REITs are popular investments, particularly for baby boomers looking for high yield investments to fund their retirement. Some large corporations pay dividends, but they are normally low yield such as 2 or 3%, since corporations also need cash to pay their taxes. In comparison, a REIT may pay 5 or 6% in distributions if it has enough profits, since it will have no tax to pay.
Stock exchange listed REIT units are eligible investments for tax deferred plans, such as Registered Retirement Savings Plans (RRSPs), Registered Retirement Income Funds (RRIFs), and for Tax-Free Savings Accounts (TFSAs). No tax usually is payable on REIT income received by an RRSP or RRIF until funds are withdrawn from the plan.
REITs have other enviable advantages when compared to other investment vehicles. REITs may trade at a premium to other investment vehicles due to their ability to pay higher distributions. REITs are therefore able to raise more capital without diluting their existing unitholders. This in turn should enable REITs to grow their investments, and enhance their profitability and ability to make distributions.