This post is part of the continuing series on income trusts written between three personal financial blogs: Financial Jungle, Million Dollar Journey and this blog. Financial Jungle and Million Dollar Journey have each written on different types of income trusts (REITS, Business Trusts, Oil and Gas and Pipelines) while I have blogged on general financial ratios one should look at for all trusts. This post deals with the taxation of income trusts on a personal level. As an opening note, I am NOT an accountant so please do not take this as advice but merely for informational purposes. Always, always, consult an accountant about your taxes (and not only at tax time either).

An income trust investor should be aware of four different types of tax consequences in owning this type of investment. Distributions can be classified as either: (i) ordinary income/interest; (ii) dividend (rarely declared but, in theory, possible); (iii) return of capital; (iv) capital gains on the sale of an income trust. Every income trust is required to provide information on how the previous year’s distributions are classified for tax purposes; given that capital gains is paid by the investor on the sale of the income trust and not by the trust, the trust obviously does not provide capital gains information. The foregoing tax information is provided to each investor on a T3 in Canada and I understand an IRS Form 1099-DIV in the United States. If you are investigating purchasing an income trust, please check the income trust’s website; most sites will provide this information (if it is not listed in a separate page; download the annual report).

Assuming you are not buying an income trust to sell, distributions which are predominantly classified as ordinary income/interest are taxed 100% on the dollar. Thus, for people in high income tax brackets or on the verge of graduating into a higher tax bracket, income trusts should ideally be held in registered retirement accounts or other tax deferral accounts (i.e. RSP, IRAs/401K). Otherwise, the addition of income from the trust could increase your taxable income or move you into higher tax bracket. For investors in lower incomes, this is not a great a consideration.

Return on capital (“ROC”) is a distribution based on cash resulting from depreciation, tax savings or the sale of equipment and assets. ROC is typically distributed to unit-holders in capital intensive income trusts such as REITS where assets are being sold or depreciated often. The primary tax effect of ROC is to reduce the adjusted cost base of the income trust (adjusted cost base, in plain English, is the price you paid for the income trust; for example if you bought 1 units for $10.00, your adjusted cost base is $10.00 and you are taxed on the gain above and beyond $10.00 on the sale of the unit).

As I understand it, ROC is not taxed when distributed to you; its primary effect to you is that it increases your capital gains on the sale of the unit since it reduces your adjusted cost base. Using the example in the previous paragraph, if your cumulative ROC during the life you held an income trust is $1.00 and you sell your unit at $12.00; your capital gains is $12.00 – ($10.00-$1.00) = $3.00.

Given that all gains made within a registered retirement account is tax-free, the tax effect of ROC to you in this situation is none at the time of sale. If the income trust is held outside a retirement account, and taxes are not deferred, on the sale of a trust with high cumulative ROC, your capital gains tax will be higher than the difference between the price of sale and the price you paid for the trust. If the gain is quite large (i.e. either you bought low and sold high or there was a lot of ROC over the life of your holding), it may be advantageous to off-set the greater than usual capital gains with any capital losses. You should consult your accountant about this matter. Income trusts with substantial ROC distributions held outside of a registered retirement account is tax efficient if you intend to hold a trust for a long period of time given that these distributions are tax-free at the time of “payment” and are taxable only at sale OR your taxable income is derived substantially from investment income (I suspect this is why Derek Foster recommends REIT’s in his book-I understand that his income is solely from investment income so ROC distribution is being paid to him tax free and, because I suspect he is not selling his REIT’s any time soon, the tax consequences will not be felt for many years down the road).

I hope this was a good 10,000 foot over-view on the tax issues surrounding income trusts. As I have stated before, do not take this as the gospel on this issue- it is merely a primer; all taxes issues should be made in consultation with your accountant.

As an epilogue to this post, Money Gardener had asked in my previous post on income trusts if a payout ratio over 100% is necessarily a bad thing and how some trusts can have a payout ratio of over 100%. My quick and dirty response is that payout ratios over 100% mean that the trust is in a negative cash flow position after every distribution and it is maintaining the payout by either borrowing money (increasing leverage for non-revenue generating activities is bad debt and bad management) or issuing new shares (creating dilution and earnings per share concerns).