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The Mail Bag: Dividend Question and Strategy

I received a couple tax related questions this week that I thought would be useful for everyone to read.

The first question was from Paul. He is curious about how dividends are taxed and how effective his dividend strategy would be. Here is the question:

a) is income from a Canadian income trust taxed differently than dividend
income?

b) can you really receive up to 57K in dividend income as a couple and not
get taxed on it. That just seems too good to be true.

The reason I ask is, I currently live in Toronto and I’m planning on moving to Peterborough, Ontario and buying a house with my girlfriend who lives there. We are looking at purchasing a new house in Peterborough for $455,000.00 With the sale of my house and the sale of her house we should be able to put about $400,000.00 down on the new house. I am considering decreasing the amount of our down payment and investing in a dividend paying stock which I hope might cover most of the monthly mortgage payment. If we put 200k down on the house and invested in a stock with the other 200k things might work out but only if…

1) the stock (or income trust/fund) pays a 10% dividend.

2) the dividend income is not taxed.

I am presently looking at the Noranda Income Fund as a possible source for
my investment.

Lets start with question A. The quick answer is yes, income trust distributions are different than dividend distributions. How so? It depends on the income trust itself, but typically an income trust distribution will include return of capital, dividends and interest. Remember, the point of an income trust is to pass on the income that they receive onto the share holder. Thus the reason why most of their distribution are taxed as income.

If you’re contemplating between an income trust or a dividend paying stock outside of a tax deferred account, it is most likely that the dividend paying stock will be more tax efficient providing that the income trust doesn’t have a huge portion in return of capital.

To answer question B, it’s not as simple as getting $57k in tax free dividends in Ontario. I’ve written about how to optimize dividend income tax before and the table indicated in the article is the maximum that you can earn INCLUDING your regular income to keep your dividends tax free.  In addition, looking back at the table, alternative minimum tax (AMT) isn’t included in the calculations.  Chances are, if you already have a decent salary to afford a $400,000 house, then you will most likely pay tax on the dividends received in a taxable account.  I would suggest that you run your numbers through a tax calculator to see what kind of tax you would face.

With that clarified, there are many holes to the strategy indicated in the question. To begin, investing half of your home value on ONE income trust would be a mistake (IMO). Income trusts are well known for paying out more in distributions and are very volatile.  What would happen if the income trust decided to stop distributions?  Could you sleep at night knowing that your $200k is all of the sudden worth $100k or less?  If income is what you are looking for, then perhaps look at income based ETF’s which purchase strong companies like XDV, CDZ or even XRE.

With that said though, 2009 may be a good time to jump into equities for the long term.

I know that the MDJ community is itching to chime in..  go ahead, what are your thoughts?

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 19 comments… add one }
  • DG January 15, 2009, 9:16 am

    You are a good candidate for the Smith Manoeuvre:

    1. Put all 400K into the house.
    2. Use a Home Equity LOC to buy 200K of income yielding investments.
    3. Interest on the LOC will be tax deductable, and the effective after-tax interest rate should be lower than the mortgage rate.

    See the other excellent SM articles on this blog for more details.

  • Four Pillars January 15, 2009, 10:18 am

    Dividends, smividends..I’d rather talk about real estate.

    $455k for a house in Peterborough? I can’t imagine houses are that expensive there which would indicate a rather large house. You might be better off buying a cheaper house for cash and investing the remainder in dividends stocks or even a dividend ETF.

    By the way – a fund/stock that pays 10% dividend is either:

    1) including a lot of return of capital – which is not taxed but is basically the same as giving you your money back or
    2) about to cut the dividend.

  • Steve in Montreal January 15, 2009, 12:17 pm

    I agree with DG and with Four Pillars with respect to the price of a house in Pete. For $455K, a blackfly net around the house fbetter be included.

  • nobleea January 15, 2009, 12:30 pm

    FP;

    It was an income trust with a 10% yield, not a 10% dividend.

    A 10% yield on an income trust is pretty conservative these days!

    455K is a lot of money for a house.
    I like the ideas of buying a smaller house with cash (maybe 350K) and then taking out a LOC and invest in good blue chip companies. The yield will be lower, but the dividends are taxed advantageously, and you don’t have to worry about the coming 2011 deadline for converting income trusts back to corporations (if the govt keeps that deadline).

  • Four Pillars January 15, 2009, 12:35 pm

    Nobleea – my statement still stands – a 10% ‘income payment’ will still be mostly ROC which is basically just getting your money back.

    Steve – lol on the blackfly net.

  • Finance_Addict January 15, 2009, 1:04 pm

    DG advice is bang-on and I second it. IMO this is by far the best solution for you. However do not go overboard with the HELOC simply looking for the highest yields. Spread your investments across sectors and I suggest you limp in over time and go well less than 50% of your home equity.

  • QCash January 15, 2009, 2:09 pm

    BMO = 31.95 as of this writing, dividend is 2.80 (unlikely to be cut given the influx of 1.2 Billion with the latest offering and the fact that even when the big banks post a loss, the generally remain cash flow positive) gives you a real dividend yield rate of 8.8%.

    The market is so out of whack with what is going on with several fundamentally strong businesses, and the public has bought into the fact that the sky is falling because many don’t remember the last recession (given that it was relatively mild and mostly hit the housing sector) that yields are crazy right now.

    Keep in mind that Alberta was making good money at $30 / barrel way back in 2006 – years and years ago.

    While 10% may generally be unachievable with dividends, taking a look at some good businesses (like BMO) who weathered a great depression and quite a few recessions, is probably not a bad idea.

    Just my $Q.02 worth.

    Q

  • nobleea January 15, 2009, 2:17 pm

    QCash, I agree on BMO.

    There’s always been a fear that they’ll cut their dividend. But they haven’t done so in 100 and some years.

    And they just spent $400 million on an insurance company. The unhealthy companies in this market are the ones that are selling assets at a discount, while the healthy ones are snapping up the deals.

    I don’t think BMO would blow $400 million if they had a remote notion that their dividend would have to be cut.

  • Arthur January 15, 2009, 3:15 pm

    While I agree with the discussion about BMO, I’d still caution: look at Bank of America, which had a stellar track record for not cutting dividends… until last year. Definitely don’t put all your eggs in one basket. Many of the other big Canadian banks have decent yields too, although not as eye-catching as BMO.

    BMO’s purchase of AIG recently is indicative that dividends should not drop, but in this environment, winds may change very quickly.

  • QCash January 15, 2009, 4:54 pm

    Just for the record, I wasn’t advocating everything in BMO (and full disclosure, I own some). I was saying that right now, there are some good dividend yields and that panic by many is setting up some great deals for the savvy.

    Unfortunately, all the crazy panic is making even the savvy take a deep breath before jumping in.

    Q

    PS And as a side note, the TSX has seen a 300 point swing since my earlier post (it was down 160 and was last up 140 or so), this sort of volatility makes all of us crazy.

  • Sauce January 15, 2009, 5:01 pm

    QCash – I’ve been lurking the MDJ site for a number of months now as I’m more interested in taking control over my own finances versus relying soley on a Fin Advisor. So, this may come off as a noob question but in regards to BMO – you mentioned a dividend of 2.80 based on the given stock price and yield (31.95 and 8.8%) but BMO is showing a dividend payout of .70c per share. I’m sure I’m misinterpreting something but not sure what….

  • Arthur January 15, 2009, 5:06 pm

    QCash,

    Amen to that. :) …and I also own a good chunk of BMO.

    Sauce,

    The $0.70 is the quarterly payout. The yearly dividend payout would be $2.80. Hope that helps!

  • Geoff January 15, 2009, 7:56 pm

    Wow – what an opportunity you have.

    Why not just buy the house outright? Anything you make as your job can be your dividends. Then invest that $ into the market and dollar cost average your way into dividend-stock heaven.

  • Sarlock January 15, 2009, 8:27 pm

    Even better. Drop the $400k in to investments and rent for the next year or two while the real estate market in Canada implodes. We’re on the edge of the cliff right now and it’s a scary long way down to go.

    We’ve sold our house and are renting a beautiful 2,200 sqft home for half of what a mortgage payment would be for the same house. Sit tight and wait for a year or two while the market adjusts and you’ll be buying the same house for $50k or $100k cheaper all the while making nice returns on your $400k investment.

  • Mark January 15, 2009, 9:56 pm

    Don’t buy the house outright. Your ROI on the house will be a long time coming, but it will occur, given the current economic climate.

    Put a sizeable down payment on the house, that will keep your mortgage payments low. Look at buying some investments, whether it be dividend-paying stocks; especially bank stocks (like BMO), CDZ EFTs, income trusts or max. out your RRSP. If you do the latter, you’ll get a hefty tax refund and you can invest that further still.

    By not putting all your money on the house, you’ll have some $100K to invest and that is pretty much a dream for most people right now, to invest with.

    Happy planning!

  • LOOPS January 16, 2009, 2:22 am

    Wow, your housing market must be cheeeeeeeeeaaaap over in Ontario. I was thinking that $455 for a new house sounded really amazing! Over here on the west coast, FYI. We are happy to see declining real estate over here, finally… markets are down about 15%, so a buyers market.

    That being said, I am a firm believer that paying down NON-DEDUCTIBLE debt first is typically the best strategy in getting ahead. This guy has unbelievable equity to put into his home. Why not sink it ALL into the house. Based on a $55K mortgage, depending on term and amortization, he could be looking at monthly amounts as little as under $300. Assuming he has a pretty decent DINK income (dual income no kids), they are laughing at the leftover amount to purchase outside of the debt, both into an RRSP and in a TFSA, as well as a regualr open investment account, all while still having the opportunity to have a HELOC on the side, waiting for further investments.

    It’s great to talk about dividend income… but if I were in his shoes, I’d be happy to have the majority of my non-ded debt paid off first, then grab an opp to do the SM with the HELOC and deduct interest on that income/dividend distribution.

    All while maintaining nerves of steel during this questionable time in the markets. DCA into investments, and you should be safe.

  • paul s January 16, 2009, 8:23 am

    Buy a house for cash. Do not take on debt. Do not leverage. Why risk it? You are in solid financial shape.

    If you buy a house for $350K, then maybe you can put the rest into TFSAs and maximize your RRSPs. If you are already doing that. Invest in a basket of ETFs, including some that pay dividends.

  • QCash January 16, 2009, 10:07 am

    Sauce

    Arthur beat me to it, but yes, you have to look at the dividend AND the schedule.

    Some trusts have a monthly distribution, so you have to check.

    http://www.tsx.ca gives you everything you need to know.

    Q

  • rwfresh January 26, 2009, 12:07 am

    455k in the Patch? I hope you are getting 100 acres with that.

    Rent a trailer at Curve Lake, take everything you’ve got and grab a margin account with IB. Put it all down on BGZ and close your eyes. In two weeks you will be a multi-millionaire.

    Move to Barbados and enjoy your new life on your sugar cane plantation.

    you’ve either got a great job that doesn’t require you being in Toronto OR you bought a house over 7 years ago. If you’ve got a great job then rent your mansion in Peterborough. The opportunity to buy is not going ANYWHERE. Unlike some on this board i wouldn’t feel comfortable investing all that money in any basket of stocks/etfs etc. let alone a single “sure thing”. Not yet. What’s the rush? That you might miss out on the rally? Don’t buy into it. Save yourself the grief and purposefully wait for this nightmare to really be over before giving your money to anyone. For a house, for stock etc.

    I think everyone should take it easy on the bargain hunting. I’m not a fatalist.. but seriously what’s the rush? When the market turns the opportunity to make money INCREASES.. it doesn’t disappear. Would you have a single regret if you were in cash in the market popped back to 14k? I wouldn’t.

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