Tuesday, March 26, 2013

Income Trusts - A Lesson Learned

In keeping with the retirement strategy described in our book Retired at 48, our portfolio concentrates on stocks that pay a steady dividend of 3.5% or higher, which we can withdraw regularly to pay our bills.  In building up this portfolio, we recently added several investments to our non-registered account that seemed to fit our criteria—relatively high dividend yield, good price to earning ratio, "Buy" recommendations from the analysts.  They also turned out to be income trusts, and we did not totally understand the tax implications of holding them outside of a RRSP or TFSA.  This tax season, we found out.

While the income trust pays on a regular basis (monthly or quarterly) similar to other Canadian stock, the money received may not be considered to be "eligible dividends", which qualify for preferential tax treatment.  The payouts from our various income trusts each contain more than one of the following components, many of which are taxed fully without the benefit of any type of reduction or tax credit.

Payout Type
Tax Implications
Eligible Dividends
Dividend tax credit which lessens the tax burden
Ineligible Dividends
Smaller dividend tax credit than eligible dividends
Foreign Dividends
Treated as regular income and taxed fully
Interest Income
Treated as regular income and taxed fully
Other Income
Treated as regular income and taxed fully
Capital Gains
50% of capital gains taxed after reduce by capital losses
Return on Capital
Reduces the purchase price of stock, so increases capital gain on sale

A new concept for us was the "Return of Capital" component of an income trust payout.  This amount is not initially taxed as income, but instead reduces the purchase cost of the income trust shares.  When you finally sell the stock, applying the reduction to the initial purchase price affects the calculation for capital gain or loss.  If you hold the stock for long enough, the price could reduce down to zero, making the entire sale price a capital gain.  If you still continue to hold the stock after the price is already zero, then you pay capital gains yearly on the additional payouts.

We had been careful to place our foreign stock and fixed income investments, such as bonds or GICs, in our registered accounts in order to shield ourselves from their tax implications.  We now realized that the income trusts needed to be treated in the same way, or we would be facing significant tax burdens which continue to increase the longer we hold the shares.

Having learned this expensive lesson, we will now take a one time hit to swap holdings, moving all income trusts to our registered and moving eligible dividend-baring stock to the non-registered.  Since we will trigger capital gains on the income trust sales, we will also sell any stock currently in a capital loss position to temper this.  We will incur the $9.99 administration fee per transaction on each sale and purchase.  Since I am buying and selling the same stock, possibly within the same day, I will try to stagger the buy and sell prices at least enough to cover to costs of the trades.  I have already successfully accomplished this for one of our stock and made a tiny profit in the process. 

Another advantage of moving the income trusts into the registered accounts is to save the hassle of calculating the tax owed on a yearly basis (let alone keeping track of the accumulating return on capital).  This is not an easy task compared to the eligible dividends.  It took several reviews of the CRA tax guide and reading multiple websites to get a good understanding of what needed to be done.  The T3 slips for income trusts also come a month later than the other tax slips, leaving less time to file your income tax.

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