What is Return of Capital?
Return of capital happens when an investor receives a portion of their original investment back, but it is not considered a capital gain. Every investment requires the use of capital, and when that original capital is returned, it is not a taxable event.
A return of capital event does, however, reduce the cost basis of an investment. When all of the original capital has been returned on an investment, any additional returns are considered capital gains for tax purposes.
How to Evaluate Return of Capital
When an investor funds an investment, that original purchase amount is considered the cost basis of the investment (also known as principal). When that principal is returned to the investor, this is a nontaxable event, but simply a return of the original funds used to buy the investment.
Return of capital should be considered whenever an investor receives a payment from an investment. While return of capital gives you quicker access to cash without the current tax bill, it does reduce your cost basis in the investment and may have poor future tax implications. Your cost basis in the investment is lowered when your capital is returned, which then causes a higher percentage of capital gains on the investment when it is sold, possibly resulting in a larger future tax bill.
For example: If you invest $10,000 in a private company, that $10,000 is the cost basis of your investment. As the business makes money, you are paid from the profits. In a down year, the business chooses to return $5,000 of your capital investment. Your cost basis is now only $5,000 in the company. If you later sell your shares for $17,000 your capital gains would be $12,000, rather than the $7,000 it would have been had your capital not been returned.
When evaluating an investment, especially in mutual funds, understanding how dividends and distributions are paid out in regards to return of capital is important. When a mutual fund’s underlying investments did not earn enough to cover a dividend payout, a fund manager may resort to dipping into the fund’s capital to pay it out. This reduces the cost basis of shareholders, as the returned capital is a tax-free distribution.
In addition, any time a business sells a capital asset, the return (up to the initial investment) is considered a return of capital, and the income generated from the sale of that asset is not taxable.
Return of Capital Example
If you invested $10 in Company XYZ and received a $5 dividend that is a return of capital after one year, that $5 payment would be tax-exempt. If, however, you received a $6 dividend in the second year, for a total of $11 in return of capital, the amount that exceeds the original investment ($1 in this case) is taxed as a capital gain.
A return of capital decreases the cost basis of an investment. If you invested $10 and then received a $1 return of capital, your cost basis becomes $9. While this may be fine if you chose to withdraw a portion of your investment, if the return of capital is paid out as a distribution, this can inflate your future tax bills due to the reduction in cost basis.
How is Return of Capital Taxed?
Return of capital is considered a nontaxable event. Most investments return your capital investment FIRST before distribution of any gains, which means that any withdrawals taken up to your principal amount are not taxed.
However, any return of capital event reduces the cost basis of an investment, meaning that there is less capital left to withdraw on a tax-free basis. Once the capital investment is fully withdrawn (or distributed), additional withdrawals or distributions from that investment are taxed at the current capital gains rate. Long-term capital gains are typically taxed at a lower rate, and apply to investments held for one year or longer. Short-term capital gains are taxed at your current year income tax rate, which is typically higher than the long-term capital gains rate.
Note: Return of capital is not the same as return on capital, as the latter refers to the return earned on the invested capital, and is considered a taxable event.