The ABCs of real estate investment trusts for rental real estate
INSIGHT ARTICLE |
Real estate investment trusts (REITs) were given legislative status under the Canadian Income Tax Act in 2007 when the Department of Finance introduced the concept of Specified Investment Flow Through (SIFT) trusts and partnerships to protect the Canadian corporate income tax base.
Prior to the SIFT rules, there was a growing trend of operating businesses through public trusts and partnerships that were listed on a stock exchange. Partnerships and properly administered trusts do not pay income tax. Rather, the income generated in a partnership is taxed in the hands of the partners and income earned in a trust, if it is paid or payable to its unit holders each year, is taxed in the hands of the unit holders. Where the partners or unit holders are exempt from income tax (e.g., a registered retirement savings plans, tax exempt pension plans, etc.), the income tax that would otherwise have been paid if it was earned in a public corporation could be avoided.
To combat this result, the SIFT rules effectively tax most public trusts and partnerships that are resident in Canada at corporate tax rates and the distributions that they make are treated as dividends to the recipients. And significantly, at the same time the SIFT rules were introduced, so was an exclusion for REITs.
Many countries around the globe have a REIT concept to give investors an opportunity to invest in commercial, industrial and residential real estate that they might not be able to do alone, in a tax efficient manner. While the Canadian rules allow for certain limited resource properties to be held in a REIT, the following content will deal with rental real estate only.
Structure and ownership
By definition, a trust must be publicly listed in order to be considered a REIT. This is due to the fact that the term is only relevant, for Canadian income tax purposes, for meeting the SIFT exception. For a number of reasons, most REITs in Canada are publicly listed as mutual fund trusts (MFTs).
While technically not a REIT for income tax purposes, the term private REIT is often used for trusts owning real property that are not listed, but are looking for investors to participate. Units of a private MFT are eligible investments for many tax deferred plans in Canada (e.g., registered retirement savings plan [RRSPs]); however, because the MFT is not public, it will not be concerned with the REIT exemption to the SIFT rules as they only apply to public trusts. However, a close ended unit trust (i.e., a trust that is not obligated to repurchase its units held by the unit holders) whose real property holdings equals 80% or more of its total property must be publicly listed in order to be considered a MFT.
In order to qualify as a MFT a trust must;
- Be a unit trust resident in Canada.
- Restrict its undertaking to investing its funds in property including acquiring, holding, maintaining, improving or managing real property that is capital property of the trust.
- Cannot be established primarily for the benefit of nonresidents.
- Have at least 150 unitholders of any one class of units who own at least “one block” of units of that class having a minimum fair market value of $500. (The number of units in a block will vary depending on the value of the unit.) For new MFTs that don’t meet this test initially, there is an election which will deem the trust to be an MFT if the test is met by the 91st day after its first taxation year.
In order to ensure that condition b) above is met, REITs are typically structured with the assets in a limited partnership with the REIT being the limited partner and a subsidiary of the REIT holding a nominal general partnership interest. While a partner is generally considered to be carrying on the business of the partnership, there is a specific exclusion for a limited partnership interest for a MFT.
Both REITs and private real estate trusts are entitled to a deduction for any amount paid or payable in the year to its unitholders. Trusts are taxed at the highest marginal rate for individuals, which is typically between approximately 48% and 53% depending on the province of residence. While REITs typically make monthly distributions, most trust deeds will require that any taxable income earned by the trust in excess of the distributions made in the year be paid or payable at the end of its taxation year which is Dec. 31. (There is an election for MFTs to have a Dec. 15 year-end for tax purposes.) The trust deed will generally allow for the distribution of REIT units which will have the same tax treatment as a cash distribution. This results in the trust being entitled to a deduction so that its taxable income is nil and the income is taxed in the hands of the unit holders, unless they are exempt from tax.
Distributed trust income is generally treated as income from property in the hands of the unitholders. To the extent the REIT has earned dividend income or realised a net capital gain, the trustees can designate to have these amounts to be taxed as dividends and capital gains in the hands of its unit holders. There is a similar designation for foreign income and foreign tax paid. If the REIT realises a loss for tax purposes in a particular year, the loss is retained in the trust and can be carried forward to reduce subsequent year’s taxable income.
Frequently, a REIT will have sufficient cash flow to distribute an amount in excess of its taxable income as a result of deducting depreciation for tax purposes. In these situations, this excess amount is not directly taxed in the hands of the unit holders. Rather, the excess will reduce the tax cost of the units so that the unit holders will have a larger capital gain, or smaller capital loss, when the units are sold. If the cost reduction results in the unit having a negative tax cost, this negative amount is treated as a capital gain in the hands of the unit holder and the tax cost is reset to nil.
There is no withholding tax on distributions by the REIT to residents of Canada. However, income distributions to nonresidents will attract a 25% withholding tax and nonincome distributions will attract a 15% withholding tax. The withholding tax rates may be reduced if there is a tax treaty with the country in which the nonresident resides. For example, withholding tax on income distributions to residents of the United States is reduced to 15% by virtue of the Convention between Canada and the United States.
There are two revenue tests that must be met to qualify as a REIT. Under the first, a minimum of 90% of the trust’s “gross REIT revenue,” defined as total revenue less the cost of any property disposed of in the year, for a taxation year must be derived from one or more of:
- Rent from real or immovable property
- Capital gains from the disposition of real property
- Dispositions of eligible resale properties (i.e., real property that is not capital property, the holding of which is contiguous and ancillary to a real property held which is a capital property)
Under the second test, a minimum of 75% of the trust’s gross REIT revenue for the taxation year must be derived from any combination of:
- Rent from real or immovable properties
- Interest from mortgages or hypothecs on real or immovable property
- Dispositions of real or immovable properties that are capital properties
The definition of real or immovable property is not restricted to real property situated in Canada. It also includes an interest in real property, buildings and their component parts as well as an investment in a REIT.
The term “rent from real or immovable properties” includes payment for services ancillary and customarily supplied or rendered with the rental of real property. Revenues from managing or operating properties, occupation of or right to use a room in a hotel or similar facility and rent based on profits are specifically excluded from being considered rent from real property or immovable property.
As a result of these rules, a REIT cannot earn more than 10% of its gross revenues from nonqualifying activities. Also, while it is permissible to earn 10% of gross REIT revenue from nonqualifying activities as well as any type of interest, dividends or royalties under the first test, the second test limits the total amount of these types of revenue to 25% of gross REIT revenue.
The rules include look-through provisions for subsidiary corporations, trusts or partnerships of the REIT so that revenues earned in those entities will be treated as having been earned by the REIT for purposes of determining whether the revenue tests are met.
There are also two asset tests, which also must be met to qualify as a REIT. Under the first asset test, a minimum of 90% of the fair market value of all nonportfolio properties held by the REIT must be “qualified REIT properties” throughout the taxation year.
Generally, nonportfolio properties includes certain investments in subject entities and Canadian real or immovable property. For the most part, subject entities are shares of a corporation, units of a trust or an interest in a partnership that is made up of residents of Canada. The REIT must own more than 10% of the equity value of the subject entity for it to be a nonportfolio property.
For a Canadian real or immovable property to be a nonportfolio property, the total fair market value of all such properties must exceed 50% of the equity value of the REIT. Canadian real and immovable property includes shares of a company and an interest in a trust or partnership if more than 50% of that entity’s fair market value is derived from Canadian real or immovable property.
In order to be a qualified REIT property, a nonportfolio subject entity must either derive 90% or more of its gross REIT revenue directly from maintaining, improving, leasing or managing real or immovable properties capital properties of the REIT (in essence, a property management company), or it owns no property other than legal title to real or immovable property of the REIT (i.e., a bare trustee), or property ancillary for the REIT to earn its rental revenues or for it to dispose of real or immovable properties that are capital properties.
Real property not situated in Canada is not considered a nonportfolio property and therefore not subject to this asset test.
Under the second asset test, throughout the taxation year, the aggregate fair market value of certain assets of the REIT cannot be less than 75% of the equity value of the REIT, defined as the fair market value of all income or capital interests in the trust. The assets considered for this test are as follows:
- Real or immovable property that is capital property
- An eligible resale property (defined earlier in this article)
- Indebtedness of a Canadian corporation represented by a banker’s acceptance
- Debt issued by or guaranteed by a Canadian government body
- Deposits with a credit union
This test allows a trust to continue to qualify as a REIT while it holds large amounts of cash from a public offering until they are invested in real or immovable properties.
Note that the fair market value of these assets can be more than 100% of the equity value of the REIT as the REIT is likely to have debt, which reduces the equity value, whereas debt does not factor into the fair market value of a property.
Unlike the first asset test, the real or immovable property does need to be in Canada. However, both tests must be met. By definition, real or immovable property includes an interest in another REIT, buildings and certain other specific depreciable property affixed to buildings.
Together, the asset tests allow a REIT to hold some investments not related to the raising of funds or operating rental properties but only to the extent of the stipulated thresholds. Whereas the revenue tests are calculated at the end of the year, the asset tests must be met throughout the year. Nonetheless, both the revenue and asset tests should be monitored regularly, as being offside will result in the trust being taxed, in effect, as a corporation. The asset tests are particularly stringent, as being offside at any time can disqualify the trust from being considered a REIT for that year.
To REIT or not to REIT
REITs are considered by many investors to be a very attractive form of investment, compared to a corporate structure holding similar assets. They provide investors with the ability to participate in real estate investments that they might not otherwise be able to make on their own as well as provide a more diverse real estate portfolio. Although a REIT may not be as secure as a fixed fund investment, investors typically see the yield as more attractive while providing a cash return typically paid on a monthly or quarterly basis; a REIT also allows them to share in the upside of a strong Canadian real estate market. REITs are particularly attractive to tax exempt investors, such as RRSPs and pension plans, as income tax is deferred until funds are withdrawn from the plans.