RETURN OF CAPITAL: Definition and How It Works

Return of Capital

Non-dividend returns on some or all of your investments in a company or fund are referred to as return-of-capital distributions. These distributions are tax-free, although they may have tax consequences.
Learn more about return-of-capital distribution, how they work, their tax treatment, what individual investors should know about them and compare return of capital vs dividend.

What is Return of Capital?

Return of capital is a taxable income category that refers to a return on investment received by an investor. It occurs when an investor receives a percentage of his or her actual investment, and the proceeds are not part of the income or capital gains category from the investment. It is critical to understand that a return of capital reduces an investor’s adjusted cost basis. Any subsequent return will be considered as capital gains after the stock’s adjusted cost basis reaches zero. Important: Return of capital is distinct from return on capital, which is the rate of return earned on the investment made and is taxable.

How Does Return of Capital Work?

An investor invests with the expectation of receiving a return at a later date. The cost basis refers to the first amount or capital invested. A return on capital occurs when an investor receives his or her principal amount back. It is not taxable because it does not include any earnings or losses. It is essentially the same as obtaining your original money back.

Some investments return capital to investors before gaining any profits or losses for taxation purposes. Qualified retirement plans, such as 401(k) or IRA, are excellent instances of the FIFO or first-in-first-out technique, in which the person receives the dollar first before profiting. The whole amount that an investor contributes to an investment is referred to as the cost basis. Adjustments can be made for stock dividends and stock splits, as well as the cost of the fee for purchasing the shares.

Financial advisors and investors should maintain track of the cost basis of their investments in order to calculate the return on capital payments. When an investor sells a stock and earns profits, he or she must record the capital gains on his or her personal tax return.

You can calculate the capital gain by deducting an investment’s cost basis from its sale price. If the payout is equal to or less than the cost basis, we can refer to it as a return of capital rather than a capital gain.

What Is a Return of Capital Distribution?

Return of capital distributions, also known as non-dividend distributions, occur when a fund returns a portion of an investor’s initial investment. It frequently occurs when a fund makes a distribution that is more than its income. Any surplus that the fund distributes is classified as a return of capital. A capital return is a non-taxable occurrence that you can’t treat as a dividend or capital gain distribution.

A return of capital distribution affects the investment’s tax base and may have an impact on capital gains taxes when the investors eventually sell their shares.

What Is the Purpose of Return of Capital Distributions?

Return of capital distributions are most common in real estate investment trusts (REITs) and master limited partnerships (MLPs). These products may return capital to shareholders to compensate for asset depreciation and drawdown. For example, depreciation is a non-cash item that affects net income but not available cash. A return to capital distribution could assist to correct this imbalance.

Return of capital may also occur in controlled payout funds. These funds aim to deliver regular monthly distributions to shareholders. If the fund does not earn enough income to cover the full monthly payment, a return of capital distribution may be made to make up the difference.

What Does This Mean for Individual Investors?

Understanding how capital returns return will help you comprehend how capital gains may influence you. When you sell your shares for more than their cost basis, a greater portion of the proceeds will be considered capital gains than if you had not received the ROC payout.

While this may appear to be a disadvantage, return of capital allows you to generate non-taxable monthly cash flow and defer capital gains taxes until you sell your shares.

After the stock’s adjusted cost basis is reduced to zero, any additional non-dividend payout is treated as a taxable capital gain that must be recorded.

Example of Stock Splits and Return of Capital

Assume an investor purchases 100 shares of XYZ common stock for $20 per share, and the stock experiences a 2-for-1 stock split, resulting in the investor’s adjusted holdings being 200 shares at $10 per share. If the investor sells the shares for $15, the first $10 is treated as a capital return and is not taxed. The extra $5 per share is a capital gain that must be on the individual tax return.

Return of Capital Tax Treatment

Return of capital distributions are not taxable, but they do have tax consequences because they may result in extra realized capital gains. If you sell a share at $11 while your cost basis is $10, you will make a $1 capital gain. However, if your ROC is $2, your per-share capital gain is $3:

 Fund with no ROCFund with ROC
Purchase price$10$10
Return of capital$0$2
Sale price$11$11
Capital gains liability$1$3

The IRS expects you to know your total capital gains based not only on the difference between your buy and sell prices, but also on your capital return.

Funds That Have Recently Made Return of Capital Distributions

Return of capital distributions are unusual for mutual funds. Here are four funds that have recently made capital return distributions.

VGSIXVanguard REIT Index FundReturn of Capital$62.3 billion
VPGDXVanguard Managed Payout FundReturn of Capital$1.7 billion
RPIBXT. Rowe Price International Bond FundReturn of Capital$4.6 billion
VIPSXVanguard Inflation-Protected SecuritiesReturn of Capital$26 billion

Dividend vs Return of Capital

While the return of capital distributions may appear to be dividends being paid out, these distributions may have different meanings.

Return of capital distributionsDividends
Occurs when you are returned part of or all of your initial investmentDistributed from a corporation’s profit and earnings
Reduces the adjusted cost basis of your stockPayer of the dividend must identify each type and amount of dividend for the investor so they can report them for taxes with Form 1099-DIV 

If you’re not clear if a payout is a standard dividend or a ROC, consult IRS instructions on how and when both occur.

Factoring Return of Capital Partnership

A partnership is a type of business in which at least two people pool their assets and share profits while running the business. Parties draft a partnership agreement, and it may be difficult to calculate the return on capital. The capital account of the partner demonstrates a partner’s interest in a partnership firm.

If a partner offers cash or assets, the capital account as well as the percentage of profits increase. When any sum is removed from the account, as well as losses incurred, the interest of the partner can be reduced. Any withdrawal up to the partner’s capital account amount is non-taxable and treated as a return of capital. After the partner receives the total capital account balance, any excess payments is the partners income and it is taxable on the partner’s personal income tax return.

How Does Return of Capital Affect My Stock Ownership?

When you receive a return of capital, you receive a portion or all of your investment in a company’s shares back, and that money is no longer invested.

The Effects of Ownership Reduction

When there is a lawful return of capital, the investor’s ownership share in the investee might reduce to the point where the investor no longer has any control over the investee. If this is the case, the investor may need to change the technique utilized to account for the investment. This usually entails shifting from the equity method to the cost method of accounting.

Return of Capital Taxation

While ROC distributions are not subject to current tax, any non-dividend distributions are considered taxable capital gains once the stock’s adjusted cost basis is lowered to zero.

What Is the Average Rate of Return of Capital?

There is no such thing as a “normal” rate of return of capital that investors may expect because the net asset value, total return on investment, and distribution rate all have varying effects on the rate of return.

Important Takeaways

  • Return of capital (ROC) is a payout or return on investment that is not deemed a taxable event and is not taxed as income.
  • Return of capital, for example, on retirement accounts and permanent life insurance policies; normal investing accounts return gains initially.
  • Investments are made up of a primary that is expected to create a return: this amount is known as the cost basis. Return of capital is the return of principal only; it does not include any gain or loss as a result of the investment.

In conclusion

Distributions of return of capital are frequently misinterpreted. You’re unlikely to see one unless you own shares in a certain group of mutual funds. Because they might have significant tax ramifications, it’s critical to understand what they mean for investors so you don’t transfer more money than you owe.

Return of Capital FAQs

Is return of capital a good thing?

If you see that your fund used a return of capital, this isn’t necessarily a bad thing. Although investors should avoid funds that use the destructive return of capital on a consistent basis, excluding a CEF from investing consideration just because it has distributed return of capital is not a good reason.

Is a return of capital a dividend?

Dividends are not distributions that qualify as a return of capital. A return of capital is the return of some or all of your investment in the company’s equity. A capital return reduces the adjusted cost basis of your stock.

What is the difference between return on and return of capital?

Understanding the distinction between Return on Capital and Return on Capital is critical because Return on Capital tells you what annual returns you can expect for your initial investment, whilst Return on Capital tells you the pace at which your initial investment can be recouped.

Leave a Reply

Your email address will not be published.

You May Also Like