# Return of Capital - good/bad?



## Retired at 31 (Apr 20, 2009)

Looking at reits and other income trusts, this seems like a good thing from an investor standpoint in a non-registered investment account. Rather than getting 100% of the distribution in taxable income, the roc comes out tax free and reduces your cost base. In the future when the unit is sold (assuming the value stays the same or rises), you are now paying tax on a capital gain at a more favourable rate. So it defers and decreases tax payable.

I'm having a hard time equating what a giant entity like a trust is doing on their side when they return capital though. I'm trying to compare to what a small corporation would have to do so that it could return capital and am drawing a blank....


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## Rickson9 (Apr 9, 2009)

Retired at 31 said:


> Looking at reits and other income trusts, this seems like a good thing from an investor standpoint in a non-registered investment account. Rather than getting 100% of the distribution in taxable income, the roc comes out tax free and reduces your cost base. In the future when the unit is sold (assuming the value stays the same or rises), you are now paying tax on a capital gain at a more favourable rate. So it defers and decreases tax payable.
> 
> I'm having a hard time equating what a giant entity like a trust is doing on their side when they return capital though. I'm trying to compare to what a small corporation would have to do so that it could return capital and am drawing a blank....


I'm not sure what you're trying to figure out and I'm sure you know this, but a REIT is a tax designation for a corporation.
http://en.wikipedia.org/wiki/Reit

To us, a REIT just looks like an (operating) profit sharing corporation with some tax benefits.

I'm not sure that I would be able to properly evaluate all the holdings in the REIT, or be happy with my entry price for all the RE in their pool of assets. As such, we have so far avoided them. If RE prices fall significantly REITs would be something we would definately look at (or we may just buy individual pieces of RE that we are comfortable holding).


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## Retired at 31 (Apr 20, 2009)

Yeah, I'm trying to compare a piece of commercial real estate in a private corp vs. a reit. I've done a bit more research and roc isn't the big bad wolf it's made out to be imo. They're just returning depreciation/amortization of the properties back to you. I'd also do the same thing with a private corp. 

The math gets interesting though - private corp is taxed at passive amount and I've heard cra watches closely for unreasonable wages coming out of the corp. Dividend is an option, but with big hit to get tax paid, it's not as attractive. I've heard some will use a 2nd corp for "property management", but this would likely still require some hoop jumping. A single address in a single city is quite concentrated, but the building I've found has a 10 year lease with a government funded agency, so it's a bit more secure than average. It's showing a 10% cap rate on cash purchase, even higher with mortgage - pending interest rates. 

I agree with the limitation to entry prices due to previous acquisitions - even a market correction isn't going to fix this for existing properties. I'm pretty bearish on RE in canada overall but commercial properties are largely a function of their return. If a reit can provide the same or similar return to a closely held corp, I think there's a benefit there. Taxation seems to be slanted in the favour of the reits from my research so far.

I'll probably end up spending some money on the guy with letters after his name to do a real life comparison. I'm smart enough to be dangerous.

It's funny how real brick and mortar in front of you can change your decision. I'm looking at 25% down on a 7 figureish building and am comfortable with it, but the thought of 250K in a reit gives me the willies.

I'd love to hear from others with rental properties in a private corp. What do you do to get around the passive income tax? Do you take full CCA? Do you extract the CCA amount or just the true profit?


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## Robillard (Apr 11, 2009)

Rickson9 said:


> a REIT is a tax designation for a corporation.


Rickson9, this assessment is incorrect. A REIT is a trust. Like most mutual funds, REITs are structured as trust such that the income distributed to the beneficiaries of the trust (the unitholders) does not lose its characterisation. REITs were deliberately left out of the 2007 income trust legislation, and are not subject to tax if they distribute almost all of their net income to unitholders.

Retired at 31, I'm afraid I don't have much advice to offer, except that it's understandable that the CRA would want to scrutinise the payment of management fees by a corporation holding property. As a shareholder of a private corporation, who also happens to be an employee, the CRA could determine that the benefits conferred by the private corporation to you through the payment of management fees are not arm's length and deny the corporation a deduction for the management fee. They would likely recharacterise some amount of the fees to be dividends and tax them accordingly. I'm not completely sure, but I think if you can demonstrate that the management fees paid by the corporation to you are equivalent to those that would be incurred in a arm's length setting, then the CRA will have a hard time recharacterising the management fee payments as dividends. 

Sorry, but I don't have much expertise in this part of the income tax act (I think subsection 15(1) applies in this situation). If anyone has questions about section 247 though, I can be of significantly more assistance.


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## Vinh Eusebios (May 19, 2009)

Return on equity will be higher than return on assets if there is debt in the capital structure.?...

Earn Extra Money


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## Rickson9 (Apr 9, 2009)

Vinh Eusebios said:


> Return on equity will be higher than return on assets if there is debt in the capital structure.?...


Correct. Return on equity is enhanced by leverage.


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## joes_k (Apr 29, 2009)

I am not a tax professional but this was how I was advised to set it up.

Provided that you are actually providing property management services (not just collecting rent) you can charge a management fee and pay it at a rate that is commercially reasonable. That means paying fees at a rate that any third party manager would charge. In my case I call several third party managers that I know and get written proposals on what they would charge to run my buildings. They typically run anywhere from 2.5 to 5% of net rent depending on the number of tenants in the building. So I pick a number in the middle and charge that as a fee. So assuming a $1 million property at a 10 cap and 3% management fee that is $3000 you could take out on base rent. It is standard practice to charge a fee on the expense recoveries as well, so there is a little more there.

You are free to take a reasonable salary as well.

You can pay the fee to yourself or take advantage of some income splitting opportunities and have the fee paid to a corporation owned by your spouse or to your spouse directly. As long as he/she is doing some property management, ie collecting rent, calling the plumber, getting the snow plowed bookkeeping etc ...

There are ways to get get cash out via dividends by playing around with CCA, depreciation and debt. But you must be very careful as there are many limitations both with CRA and the business corporations act. So in my experience it just isn't worth the brain damage

Do yourself a favour and get professional advice on how to best set this up.

BTW, a 10 cap for a government covenant almost sounds too good to be true. Get more info on this agency because buildings with gov't covenants go for around a 6 cap.

Good luck!!

PS I own REITS as well as my own portfolio of property. But thats a whole other post.


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## Rickson9 (Apr 9, 2009)

joes_k said:


> BTW, a 10 cap for a government covenant almost sounds too good to be true. Get more info on this agency because buildings with gov't covenants go for around a 6 cap.


Very good (and important) point!


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## leslie (May 25, 2009)

"I'm having a hard time equating what a giant entity like a trust is doing on their side when they return capital though."

This example walks you through the process. Assuming the measurement of income is correct, the Return of Capital must come from either issuing more shares or more debt or else it will shrink the business. 

Real Estate businesses book about 4% depreciation which really overstates those costs. 2% is a better estimate. 

Also they have been paying out as distributions part of the unrealized capital gains on the properties they own. Since those values have fallen now, that problem has come home to roost.


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## Retired at 31 (Apr 20, 2009)

Thanks leslie. I'll have to take a closer look at the issued shares in a couple of benchmark reits I was comparing. The local building is on hold for the moment - the "government agency" turned out to be a non-profit who has some government funding - a key distinction that the broker didn't communicate.


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## leslie (May 25, 2009)

I'll say!


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