How Return of Capital Is Taxed

In DIV 302 you learned that return of capital (ROC) can mean very different things economically. This lesson is about the tax side, which works the same way whatever the reason: ROC isn’t taxed when you receive it, but it doesn’t disappear either. It moves into your cost basis and waits.

Cost basis, quickly

Your cost basis is what the tax system considers you paid for your shares, including any reinvested dividends. When you sell, your taxable gain or loss is the sale price minus your basis. Return of capital lowers that basis.

How it works, step by step

When the basis reaches zero

If a fund keeps paying ROC for years, your basis can fall all the way to zero. From then on, every dollar of ROC is taxed as a capital gain in the year you receive it: long-term if you’ve held the shares for more than a year. Try the tracker to see how quickly a high ROC payout can get there:

Why the deferral can be worth a lot

• Time. Tax you pay in ten years instead of today stays invested in the meantime.
• Lower rates. Ordinary dividends can be taxed at up to 37%. The gain that ROC eventually creates is usually long-term, taxed at 0%, 15% or 20%.
• Step-up at death. Under current law, heirs generally inherit shares with their cost basis reset to the value at the date of death. Tax deferred through ROC can then never be collected.
• Control. You decide when to sell, and can sell in a low income year or offset gains with losses.

This is exactly why some option income funds, like those using index options described in Section 1256 and the 60/40 Rule, actively manage their gains and losses so that much of their payout is classified as ROC. For a taxable investor, that can make a big difference to the after-tax income.

But a tax break doesn’t fix a shrinking fund

If ROC is the destructive kind, where the fund is simply handing back your money, the tax treatment is almost beside the point. Getting your own money back tax free is no great gift. Judge the investment on total return first and the tax second, as described in Return of Capital.

The record keeping traps

• Check your broker’s basis. For shares bought in recent years, brokers track basis and should adjust it for ROC. Older positions, or shares moved between brokers, may not be adjusted. If ROC isn’t subtracted, you’ll under-report your gain; if reinvested dividends aren’t added, you’ll over-report it and pay tax twice on the same money.
• Watch for corrected 1099s. ROC figures are often finalized after year end. See Reading Your 1099-DIV.
• Reinvested ROC buys new shares with their own basis, while lowering the basis of the shares that paid it. Good software handles this; spreadsheets often don’t.
• MLPs are different. Their ROC also lowers basis, but part of your gain on sale may be taxed as ordinary income (depreciation recapture). See How REIT, BDC and MLP Payouts Are Taxed.