Taxation of Income Trusts

by Tax Guy - Burlington Accountant on July 9, 2008 Print This Post Print This Post

Income trusts, real estate investment trusts, and royalty trusts are a form of entity know as a “flow through entity” because the cash flows generated in the trust are flowed through to the trust unit holders proportionately in the form they were received by the trust.

The commonly used term “income trust” is more specifically a “business income trust.” It is a trust that earns income from operating some underlying business. Similarly, a real estate investment trust is essentially the same as a “business income trust” except that it earns income from real estate.

The units of both forms of trusts are different form the shares in a public company. In a public company the investor holds shares and is entitled to receive dividends which may be eligible for the dividend tax credit. If the client decides to sell their shares they will incur a capital gain or capital loss accordingly. On the other hand, both real estate investment and income trusts are what we call “flow through entities” because the cash flows generated within these trust are “flowed through” to the unit holders proportionately in the form they were received by the trust. In many ways this is very similar to how a mutual fund flows income to its unit holders. In addition the cash distributions from both forms of trusts may also include a return of capital.

Tax Treatment

The cash distributions from these trusts can be in the form of interest and normal income, dividends, capital gains, and a return of capital.

The distributions are typically made up from income and interest which are both taxed as normal income in the unit holders’ hands.

The distributions may include net capital gains. Note however, that like a mutual fund only the net capital gains are flowed through to the unit holder. Net capital losses are not passed along to the unit holder but rather held by the trust to offset future capital gains.

The distributions may also include taxable dividends from investments held within the trust. The dividend income would be passed along to the unit holder and, if the dividend is eligible, would qualify for the dividend tax credit.

The distributions can also include a return of capital which is not taxable when received. However, the ROC reduces the cost base of the unit holders’ trust units held and will result in a higher capital gain or lower capital loss when the units ultimately sold. Note that If the ACB falls below zero the negative amount is reported as capital gain and the ACB is set to zero.

It is important to understand that the distributions from these trusts are not always the same and the mix of capital gains, dividends, income, and a return of capital. Depending on the year and a variety of other conditions these allocations can vary significantly and can have an impact on your after tax returns.

Reporting

The trust will distribute a T3 tax slip annually and will report the allocations of the various types of income to you.

About The Tax Guy...

Dean Paley CGA CFP is a Burlington accountant and financial planner who services individuals and business owners locally, nationally and internationally. Dean has appeared in the National Post, Toronto Star and Metro News.

To find out more, visit Dean's website Dean Paley CGA CFP or connect via Twitter @DeanPaleyCGACFP.

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