I don’t understand the recent ‘special distribution’ by Canadian Apartment Properties Real Estate Investment Trust (CAR.UN). The distribution was supposed to be paid in additional units at the end of December, but the number of units I own hasn’t changed. Did CAP REIT or my broker drop the ball?
Nobody dropped the ball. This is what’s known as a reinvested – or “phantom” – distribution, so named because no cash changes hands and the number of units doesn’t change, either. Many investors are understandably puzzled by these distributions, but it’s important to understand how they work so you don’t end up paying more tax than necessary down the road.
Phantom distributions typically consist of capital gains that a REIT – or, more commonly, an exchange-traded fund – realized during the year and reinvested internally. The purpose of the year-end distribution is simply to push the capital gains tax liability into the hands of the unitholder. That’s all.
In CAP REIT’s case, the non-cash distribution of 49 cents per unit represented a portion of the capital gains it triggered in 2023 by selling certain older, non-core properties. Those capital gains, combined with CAP REIT’s increased operating income, created a situation in which the REIT’s taxable income for the year exceeded the total value of its regular monthly distributions. So the REIT “distributed” the excess to unitholders, but only on paper, for tax purposes.
Let’s be clear: This wasn’t some underhanded trick by CAP REIT to avoid paying tax. “It is a requirement that the REIT itself has to distribute all taxable income to its unitholders under the declaration of trust,” Stephen Co, CAP REIT’s chief financial officer, explained in an interview. It’s not just CAP REIT; all REITs are supposed to distribute their taxable income, although in some rare cases that doesn’t happen and the REIT may face a tax hit.
But if no cash changes hands, how exactly does a REIT distribute a capital gain?
Initially, CAP REIT did distribute – at least in theory – additional units to investors in an amount equivalent to the value of the special distribution. Immediately thereafter, however, it consolidated the total number of units outstanding such that investors held the same number of units, with the same total value, as before the distribution. The only thing that changed was that unitholders would now be responsible for paying capital gains tax on the distributed amount.
It’s not necessary to understand the mechanics. But if you’re investing in a non-registered account, you will need to add the value of the distribution to the adjusted cost base of your units. By raising your ACB, you’ll report a lower capital gain, or a higher capital loss, when you ultimately sell your units, reflecting the fact that you already paid tax on the reinvested distribution.
If you don’t raise your ACB, you’ll effectively end up paying tax on the phantom distribution twice – once now, and a second time when you sell.
With tax season approaching, I recommend that investors holding REITs or ETFs in a non-registered account check to see if any of their securities has declared a reinvested distribution for 2023. You can find this information in the table of “distribution characteristics” published on ETF company websites. Your broker might make the ACB adjustment for you, but if not, you’ll want to update your ACB accordingly.
I have three self-directed investment accounts: a registered retirement income fund, a tax-free savings account and a non-registered account. All three currently hold some cash, which I want to put back into the market. I am considering investing some of that cash in the Magnificent Seven technology stocks. For Canadian income tax purposes, which of my three accounts would be best?
In a TFSA, there are no taxes on capital gains, which is the main objective of investing in tech stocks. What’s more, while you would still face a 15-per-cent withholding tax on U.S. dividends in a TFSA, only three of the Magnificent Seven – namely, Apple Inc. AAPL-Q, Microsoft Corp. MSFT-Q and Nvidia Corp. NVDA-Q – pay any dividends at all, and their yields are tiny. So the amount of withholding tax would be minimal. For these reasons, a TFSA would be a perfectly acceptable place to invest in big tech.
In a non-registered account, on the other hand, you will face capital gains tax when you sell stocks that have appreciated. You’ll also face a 15-per-cent withholding tax on U.S. dividends, as well as Canadian income tax on foreign dividend income, although you can usually claim a foreign tax credit for the tax withheld (which is not the case with a TFSA). What softens the blow somewhat is that, in a non-registered account, only 50 per cent of capital gains are included in income.
As for your RRIF, there are no Canadian income taxes on capital gains or dividends and no withholding taxes on U.S. dividends, thanks to the Canada-U.S. tax treaty.
Keep in mind, however, that a RRIF consists of pre-tax dollars. If you have, say, $500,000 of assets in a RRIF and your marginal tax rate is 40 per cent, the theoretical after-tax value of your RRIF is effectively $300,000 (60 per cent of $500,000).
Similarly, if you were to invest, say, $50,000 of your RRIF money in the Magnificent Seven, at a tax rate of 40 per cent that would be economically equivalent to investing just $30,000 in your TFSA or non-registered account, both of which are funded with after-tax dollars. In other words, a dollar invested in a RRIF will effectively give you less exposure to the Magnificent Seven than a dollar invested in a TFSA or non-registered account.
There are a lot of moving parts here, including whether you have other investments that might generate even greater tax savings by parking them in your TFSA or RRIF instead of using your finite registered account space for your tech investments.
Finally, while many tech stocks have produced fabulous returns in recent years, remember to maintain a diversified portfolio and not get too overweight in any one sector lest the trend stops being your friend.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
John Heinzl