Why would you put REITs into the TFSA before non-reg?

Don't REITS have more tax advantaged income, or is it that they generate more total income, period, compared to dividend paying equities, in general.

In retirement, having REITs in your non-registered accounts is not a bad thing for added income because your tax rates would theoretically be much lower. But during higher income working years, it's not worth it unless you really value the diversification. The majorities of returns from REITs come from their income and income is taxed one way or another as you realize it. This income is not in the form of a Canadian eligible dividend. REIT distributions are a combination of Other Income, Foreign Non-Business Income, Capital Gains, and Return of Capital. If you look at the top REITs in Canada, the vast majority of distribution income is in the form of Other Income and Return of Capital. For tax purposes I'll break it down by type:

- Other Income: Taxed at your highest marginal tax rate (similar to employment income)
- Foreign Non-Business Income: Taxed at your highest marginal tax rate (similar to employment income)
- Capital Gains: Taxed at 50% of your highest marginal tax rate
- Return of Capital: A pain in the ass. This income isn't taxed immediately, but it reduces the cost base of that REIT holding. Once the cost base goes to $0, it gets taxed as a Capital Gain. If you sell the units, you have to adjust your cost base to properly calculate the true capital gains.

For example, lets say you buy 100 units of a $10 REIT that pays a 10% distribution. The distribution is equally split between Other Income and Return of Capital. You live in ON and make $74000/yr with your employment so your highest marginal rate is 31.5%.

Year 0 -- Cost Base: $1000 -- Income: $0 -- Tax: $0

Year 1 -- Cost Base: $950 -- Income: $100 -- Tax: $15.75 (OI $50 x 31.5%)

Year 2 -- Cost Base: $900 -- Income: $100 -- Tax: $15.75 (OI $50 x 31.5%)

.....Years go by.....

Year 20 -- Cost Base: $0 -- Income: $100 -- Tax: $23.62 [$15.75(OI $50 x 31.5%)+$7.87(ROC$50 x 15.74%)]

Now your marginal tax rate is 23.62%. This compares to a eligible dividend tax rate of 8.92%. So your after-tax return on your investment has dropped to 7.64%. Still not bad though, right.

Now you decide to sell. Your investment is still worth $1000. Your adjusted cost base is $0, so you have to claim all $1000 as a capital gain and you're left with: $842.60 after tax. Plus after tax income over the years of $1685 ($84.25 x 20) for a total net return of $1527.60 after you deduct the cost of your initial investment.

Let's compare the same with a Canadian dividend paying stock. Same 100 @ $10/unit pays 3% dividend (doesn't ever increase) and 5% annual capital gain.

Year 0 through Year 20 -- Cost Base $1000 -- Income: $30 -- Tax: $2.58

Now you decide to sell. Investment is worth $2685. Cost base is $1000. You claim $1685 as capital gain and you're left with: $2419.78 after tax. Plus after tax income over the years of $548.40 ($27.42 x 20) for a total net return of $1968.18 after you deduct the cost of your initial investment.

This is despite a lower annual return of 8% vs 10% with the REIT.

Clearly I could spin the numbers in many different ways, but I think the following is pretty safe to say: over a long period of time the before tax return of a REIT index will be similar to the before tax return of the Canadian stock index, although they won't follow the same track because REITs should perform better than stocks when interest rates drop and worse when interest rates rise. But... for a working person enjoying a good income, in a non-registered account the Canadian stock index will likely perform better than the REIT index due to less favorable tax circumstances for REITs. To get around this tax drag, the TFSA is a good place to realize the maximum return for REITs.