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Is it Wrong to Invest in REITs in RRSPs?

Real estate investment trusts (REITs) are income trusts that allow you to easily invest in real estate for monthly rental income. Investors should distinguish equity REITs (or eREITs) from mortgage REITs (or mREITs). eREITs invest in real estate properties, while mREITs provide financing for real estate. So, generally speaking, eREITs are safer investments.

How are Canadian REIT distributions taxed?

Canadian REITs are great income investments. Investors can easily find REITs with safe yields of 6% or higher. However, notably, REITs pay out distributions, which are taxed differently from the eligible dividends that most investors are used to.

Eligible dividends are taxed at favourable rates in taxable, non-registered accounts. How are Canadian REIT distributions taxed? Well, it depends. This is because REIT distributions can comprise of return on capital, capital gains, other income, and foreign non-business income.

In non-registered accounts, the return of capital portion is tax-deferred until unitholders sell or the adjusted cost basis of the REIT investment turns negative.

So, return of capital is essentially taxed like capital gains — at half your marginal tax rate. Then there’s other income and foreign non-business income, which are taxed at your marginal tax rate.

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Should you hold Canadian REITs in RRSPs?

Northview Apartment REIT (TSX:NVU.UN), H&R Real Estate Investment Trust (TSX:HR.UN), Plaza Retail REIT (TSX:PLZ.UN) offer safe yields of roughly 6.8%.

Because REITs don’t pay eligible dividends, they are more of a hassle for tax reporting in a non-registered account. That’s why some investors hold them in RRSPs or TFSAs.

However, for REITs with high portions of return of capital (which are tax-deferred), it’s really defeating the purpose to hold them in RRSPs, seeing as most returns from REITs will most likely come from their cash distributions.

On the contrary, if you find high-growth REITs or undervalued REITs that you believe will revert to the mean and appreciate big time at one point, it might make sense to invest in them in TFSAs or non-registered accounts.

What about U.S. REITs?

There’s a 15% withholding tax from dividends paid out from U.S. REITs held in non-registered accounts. So, ultimately, these foreign dividends will be taxed at the marginal income tax rate.

In RRSPs, there’s no withholding tax on the foreign dividends. So, investors can get the full dividend from U.S. REITs. You won’t get taxed until you withdraw from your retirement account, and the amount will be counted as taxable income.

Simon Property Group Inc. (NYSE:SPG) is a leading U.S. retail REIT that’s out of favour right now and offers a safe 5% yield. Other than focusing on the top-tier markets in the U.S., it also has iconic properties in other parts of the world, including in Japan, Canada, Korea, Austria, Germany, Malaysia, Mexico, the Netherlands, and the United Kingdom.

Investor takeaway

Investors should invest in Canadian REITs with distributions having high portions of return of capital outside of RRSPs. The tricky part is that the percentages of the constituents in REIT distributions can differ every year.

Investors should hold U.S. REITs with high yields, such as Simon Property, in RRSPs. However, investors might find it’s more tax-efficient to hold REITs with high growth and small yields in taxable non-registered accounts because most of the returns will come from capital appreciation, which is tax-deferred until you sell.

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Fool contributor Kay Ng owns shares of Simon Property Group and Plaza Retail.

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