Income trusts have creative ways of sustaining their cash distributions through returns of capital.
Many investors question how any organization can continue to distribute cash to its owners in excess of its earnings. Sure, it can do so for a while, using excess cash. And it can extend that while using borrowed money. But aren’t these tactics ultimately self-defeating? This question brings up that of the real meaning of earnings in the generally-accepted-accounting-principles (GAAP) sense.
An analogy may help. Suppose you bought a 10-unit apartment building in 2000 for $1 million with a mortgage of $700,000 and equity of $300,000. You charged rents of, say, $1,000 a unit per month for total annual revenue of $120,000. Further, suppose your operating, maintenance and financing costs totaled $80,000. That left you with a profit of $40,000 on your investment.
Today, however, the inflation of the past 21 years plus the fact that your building is now in a more attractive location due to urban developments means you can charge $2,000 a month, or $240,000 a year. Further, suppose your expenses have risen to $160,000. That means you have doubled your operating profit to $80,000. Arguably, your building is now worth twice as much—$2 million. So you refinance at, say, $1,400,000 and pay yourself a nice bonus of, perhaps, $300,000.
What it means to the CRA
What does that bonus mean to the Canada Revenue Agency? It means return of capital up to your initial investment of $300,000, which is not immediately taxable. You’ve simply taken your money off the table. Mind you, had you paid yourself $400,000—more than your original investment, you’d have a capital gain of the amount of the excess—$100,000.
In our example, you’ve now got equity of $300,000 ($2 million less $1,400,000 mortgage less $300,000 bonus), just as when you started. Is this a sustainable process? Perhaps not.
But suppose we enter a period of deflation. Rents fall. You have trouble meeting your mortgage payments. Maybe the mortgagee forecloses. You lose everything. But in real terms, you have nothing invested. You got all your capital back—plus some profit along the way. If the market value of your building falls below $1,400,000, the mortgagee will lose. But then, he’s taken that risk in return for a yield far greater that that of treasury bills.
Accountants can spread (accrue) this process over many years, giving investors some profit and some return of capital each year. That’s exactly what real estate investment trusts and many income trusts do.
Take CAP REIT, for example. For the 2020 taxation year, 43.8 per cent of the REIT’s distribution was taxable as regular income, 0.1 per cent was taxable as dividend income, and 56.1 per cent was a return of capital, meaning it was not taxable and should have been deducted from the adjusted costs base of your units.
This is an edited version of an article that was originally published for subscribers in the November 26, 2021issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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