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yield hog

In a recent column, I mentioned that holding real estate investment trusts in a registered account avoids the tax headaches associated with REIT distributions.

"Are you nuts?" was the reaction from some readers. REITs get preferential tax treatment in a non-registered account, and if you hold them in a registered retirement savings plan you'll be squandering the wonderful tax benefits, they said.

This is a bogus argument, as I'll demonstrate shortly.

I often hear the same – equally flawed – argument against holding stocks inside an RRSP. The reason given is that investors supposedly "lose" the tax breaks on dividends and capital gains and end up paying full tax on every dollar withdrawn from their RRSPs.

As spurious as this reasoning is, it's widely accepted. I've even heard it from finance professors and CEOs of investment firms. The reason so many people believe this myth is that they make a crucial mistake in their analysis: They assume a dollar inside an RRSP is equivalent to a dollar outside, when they're not the same at all.

In a previous column, I showed that dividend stocks will always deliver a superior after-tax return if held inside an RRSP, assuming the same (or lower) marginal rate when money is withdrawn.

Now, let's look at REITs.

Consider two investors, Brad and Angelina. For simplicity, we'll assume their marginal tax rate is 50 per cent.

Brad decides to purchase $100,000 of XYZ REIT in his non-registered account. The key thing to note here is that, because he is investing outside his RRSP, he is using after-tax dollars.

To end up with that $100,000, he would had to have earned $200,000 in pretax income (the other $100,000 went to the taxman).

Now, let's assume Brad's $100,000 investment in XYZ yields 6 per cent or $6,000, divided equally between return of capital or ROC ($2,000), capital gains ($2,000) and other income ($2,000). Let's further assume that Brad holds XYZ for one year and then sells his units for $110,000.

What will Brad's after-tax return be?

The first thing we need to do is subtract the $2,000 of ROC from Brad's cost base of $100,000, reducing it to $98,000. His capital gain on the sale is therefore $12,000 ($110,000 minus $98,000). Because only half of this amount – or $6,000 – is included in his income and taxed at his marginal rate of 50 per cent, his tax on the sale is $3,000.

But Brad also has to pay tax on his distributions – namely $1,000 of tax on other income and $500 of tax on capital gains. (There are two types of capital gains here: one from the sale of Brad's units, and the other distributed by the REIT itself).

After subtracting the $4,500 in total taxes from Brad's gross proceeds of $116,000 ($110,000 plus $6,000 in distributions), Brad is left with $111,500. That's an after-tax return of 11.5 per cent.

Now let's see how Angelina would make out.

Unlike Brad, Angelina appreciates the tax benefits of RRSPs. She decides to invest an equivalent amount in XYZ REIT but holds it in her RRSP instead.

But what is an equivalent amount?

Remember that Brad invested $100,000 after-tax, which, at a 50-per-cent tax rate, is equivalent to $200,000 pretax. So to make this a fair comparison – and this is the part that trips up a lot of people – Angelina would have to invest $200,000 in her RRSP, which contain pretax dollars.

Assuming Angelina's $200,000 grows at the same 10-per-cent rate and generates the same 6-per-cent yield, at the end of one year she would have $232,000 in her RRSP.

If she were to then sell her units and withdraw all the cash, she would pay tax of $116,000 (50 per cent of $232,000), leaving her with $116,000. This works out to an after-tax return of 16 per cent – significantly better than Brad's return of 11.5 per cent.

Wait. Let's circle back to the myth: Isn't Angelina supposed to be worse off because she pays all that tax on her RRSP withdrawal and gives up the supposed tax breaks that Brad gets?

In fact – and this is another key point some people miss – the tax on Angelina's RRSP withdrawal is really just the initial income tax she deferred ($100,000), plus the growth of that tax (16 per cent of $100,000, or $16,000), for a total of $116,000.

In Brad's case, he pays the taxman $100,000 up front and, like Angelina, gives up the growth of that $100,000. But unlike Angelina, he's on the hook for even more tax. Specifically, he has to pay tax on XYZ's distributions and on the capital gain when he sells – that's $4,500 in tax that Angelina doesn't have to pay. That's why Angelina comes out ahead.

Granted, if one's tax rate is going to be a lot higher in retirement, RRSPs may not be the best choice. But I'm assuming the tax rate stays the same. Many people expect to have a lower tax rate in retirement, which makes the case for RRSPs even stronger.

You can do the same analysis with any investment and vary the time periods all you like. But if you do a proper comparison, RRSPs will always win.