Where is the Best Place to Buy REITs?
REITs or real estate investment trusts allow you to easily invest in real estate for rental income. You can buy residential REITs, retail REITs, healthcare REITs, office REITs, etc. Generally, REITs pay out high income called distributions. However, they are different from stocks that pay out dividends.
Investors generally buy REITs for their high income. But investors need to consider where to buy high-yield REITs to avoid as much tax as possible for the high income. That is, to buy in a non-registered, TFSA, or RRSP account. First, we need to gain a better understanding of REIT distributions.
How are REIT Distributions Different from Stock Dividends?
REIT distributions may consist of other income, foreign non-business income, capital gains, and return of capital. Other income and foreign non-business income are taxed at your marginal tax rate, while capital gains are taxed at half your marginal tax rate.
However, the return of capital portion is not taxed until the adjusted cost basis goes to negative. If you buy a Canadian REIT in a non-registered (taxable) account, the T3 you receive will help you determine how much to deduct from the adjusted cost basis for the year.
Where to buy Canadian REITs?
Because the return of capital part of the distribution reduces the adjusted cost basis, investors should consider buying REITs with a big percentage of return of capital in the distribution in the non-registered account.
An investor can only assume whether a REIT pays a good portion of its distribution as return of capital via the “Tax Information” section of a company website, by looking at the tax information of the distribution in past years. At least, so far, I haven’t found a better way.
For example, for Northwest Healthcare Properties REIT (TSX:NWH.UN), since 2010, over 94% of its distributions is return of capital. This means that 94% of the income you receive if you had bought its shares in the non-registered account, wouldn’t be taxed until later.
If Northwest keeps this up, it’ll take about 14 years before you’ll need to start paying taxes on its distributions. Of course, if you sell the units beforehand, you’ll need to pay tax on the capital gains based on the reduced adjusted cost basis. See this article for a concrete example about this income tax-deferral strategy.
In essence, if a REIT you like has a big portion of distribution as return of capital, it makes sense to buy it in the non-registered account for tax-deferral purposes. However, you need to keep track of the reduced adjusted cost basis as a result. So that when you sell, you have that number ready.
If you hate doing Math, then, you’re better off investing in the TFSA and RRSP. But you should contribute in a TFSA first because everything earned in there is tax-free, and you can take it out anytime so it’s more flexible than a RRSP. Just make sure you don’t contribute back into the TFSA until the next calendar year unless you still have contribution room left from before.
Where to buy US REITs?
As far as I understand, US REIT distributions in the RRSP generally have no withholding tax. Investing in the non-registered account, you pay the marginal tax rate on foreign income anyway, so it doesn’t matter that there is a withholding tax on the foreign distribution. I’ve only held one US REIT in my non-registered account before, and the withholding tax was 15%. I don’t know for sure whether the same rate applies for all US REITs.
Where to buy US REITs depends on your tax situation because no one knows what marginal tax rate you will be taxed at in retirement. You will have the best idea though. Do you think your tax bracket will be lower in retirement than now? If yes, you should invest US REITs (and US high dividend stocks) in your RRSP.
To keep it simple, buy Canadian REITs in a TFSA or RRSP. To take advantage of the tax-deferral nature of the return of capital, buy Canadian REITs with a big portion of distributions from return of capital in a non-registered account. Just keep in mind you need to reduce the adjusted cost basis and that we have no control of how much return of capital will be in future distributions.
For US investors wishing to buy Canadian REITs, check the company website to see how much tax is withheld on the distributions.
Investors can reinvest REIT distributions at a discount. However, you’ll need to track the adjusted cost basis unless you buy in a TFSA or RRSP.
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Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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