Learn more about what return-of-capital distributions are, how they work, and what individual investors need to know.
Definition and Examples of Return of Capital
Return of capital, also known as “ROC,” is a return of some or all of an investment in a stock or fund. ROC distributions aren’t considered dividends even though ROC could be included in a fund distribution because a ROC is the original money you invested. While your fund provides tax liability estimates throughout the year, the 1099-DIV the fund sends at the end of the year will show the exact amount of ROC you received during the year. An example of a ROC would be when a fund pays out a distribution comprising the returns a fund generated, plus the money you invested. The returns are considered income, while the return of your capital is not.
How Does Return of Capital Work?
Let’s say that you buy 100 shares of a fund at $10 per share. Your initial purchase cost $1,000 (100 x $10), making your initial per share cost basis $10 ($1,000/100). If you buy another 100 shares at $12 per share, you would now have spent $2,200 (100 x $10) + (100 x $12) in acquiring 200 shares. This would make your overall cost basis $11 ($2,200/200). Now suppose over one year, the fund pays you a $4 distribution per share, resulting in an $800 payment (200 shares x $4) at the end of the year. When you receive your 1099-DIV, you find out that $3 of the distribution came from income and interest the fund earned and $1 was a ROC. Because $1 of your annual distribution per share was a ROC, your adjusted cost basis goes down from $11 to $10. Because your cost basis went down $1, if you sell your shares at a profit, your realized capital gains go up $1.
Tax Implications
Return of capital distributions aren’t taxable, but they do have tax implications because they might produce additional realized capital gains. Selling a share at $11 when your cost basis is $10 will result in a $1 capital gain. But if your ROC was $2, then your per-share capital gain is $3:
What It Means for Individual Investors
Being aware of how return of capital works can help you understand how capital gains could affect you. When you sell your shares for more than the cost basis, more of that money will be considered capital gains than if you hadn’t received the ROC distribution. While that may sound like a negative, return of capital gives you the chance to earn non-taxable monthly cash flow, and you can defer capital gains taxes until you sell your shares
Return of Capital vs. Dividends
While return of capital distributions can feel like dividends being paid out, these distributions can have different implications.
