Return of Capital
A “return of capital” refers to the return of an investor’s principal amount in an investment. Unlike dividends or interest, which are returns on an investment, a return of capital is a portion of the original investment amount (or capital) being given back to the investor. Essentially, it’s a repayment of the investor’s cost of the investment rather than an earned profit.
A return of capital reduces an investor’s adjusted basis in the investment. Once the adjusted basis is reduced to zero, any further amounts received from the investment are generally considered capital gains for tax purposes.
Several scenarios where a return of capital might occur include:
- Distributions from a Partnership or LLC: If a partnership distributes more money to a partner than their share of the company’s profit, the excess amount can be considered a return of capital.
- Real Estate Investment Trusts (REITs): REITs often distribute a significant portion of their income to shareholders. Sometimes, these distributions can exceed the REIT’s taxable income due to various deductions like depreciation. The excess distribution, over and above the income, can be treated as a return of capital.
- Non-dividend Distributions: If a corporation returns money to shareholders without it being a dividend (maybe because they didn’t have sufficient earnings and profits), it can be considered a return of capital.
- Sale of Fixed Assets: If a company sells its assets and returns a portion of the sales proceeds to shareholders, it can be viewed as a return of capital.
- Mutual Funds: Sometimes, mutual funds distribute capital gains and other returns to shareholders. If a fund returns more than it earned, the difference can be a return of capital.
From a tax perspective, a return of capital is typically not immediately taxable. Instead, it reduces the investor’s cost basis in the investment, which will impact the capital gains or losses realized when the investment is eventually sold. If an investor’s basis is reduced to zero by returns of capital, then any subsequent returns of capital would be taxable as capital gains.
Example of a Return of Capital
Let’s explore a return of capital using the context of a Real Estate Investment Trust (REIT).
Scenario: REIT Distribution and Return of Capital
John invested $10,000 in a REIT called EstateTrust. At the end of the year, EstateTrust distributes $900 to John. This distribution is broken down as follows:
- $600 from rental income (after expenses and depreciation).
- $300 from the sale of a property which was primarily a return of the original investment, rather than profit.
From John’s perspective, the distribution can be viewed as:
- $600 dividend income, which is taxable in the year received.
- $300 return of capital.
Tax Implications for John:
- The $600 dividend income would be reported on John’s tax return, and he would pay taxes on this amount based on his applicable tax rate for dividend income.
- The $300 return of capital is generally not immediately taxable. Instead, John would reduce his basis in EstateTrust by this amount.
Original basis in EstateTrust: $10,000 Less: Return of capital: $300 New basis in EstateTrust: $9,700
Now, if John were to sell his investment in EstateTrust, his capital gains or losses would be calculated using the new basis of $9,700.
Let’s say a year later, EstateTrust distributes another $1,000 to John, of which $700 is from income and $300 is a return of capital. However, by this time, John has received cumulative returns of capital that have reduced his basis to zero (for simplicity, assume other factors remain constant). In this case:
- The $700 would be treated as dividend income.
- The additional $300, since it’s beyond the reduced basis, would now be considered a capital gain for John and he’d have to report it as such.
This example highlights the importance of tracking the adjusted basis in an investment and understanding the tax implications of different types of distributions.