What Is Return of Capital (ROC)?
Let me explain return of capital, or ROC, directly to you: it's a payment you receive as an investor that gives back part of your original investment, and it's not treated as income or capital gains from that investment. You should note that this kind of return reduces your adjusted cost basis in the investment. Once that cost basis drops to zero, any further returns you get will be taxable as capital gains.
Key Takeaways on Return of Capital
Understand that ROC is a payment or return from an investment that isn't a taxable event and isn't taxed as income. For instance, capital gets returned in retirement accounts and permanent life insurance policies, while regular investment accounts typically return gains first. Your investments consist of a principal that should generate returns, and this principal is your cost basis; ROC is simply the return of that principal, without any gain or loss from the investment itself.
How Return of Capital (ROC) Works
When you invest, you're putting your principal to work to generate a return, and that principal is known as the cost basis. If the principal is returned to you, that's ROC. Since it doesn't include any gains or losses, it's not taxable—it's essentially like getting your own money back. Don't confuse return of capital with return on capital; the latter is the taxable return you earn on your invested capital.
Certain investments let you receive your capital back first before any gains or losses for tax purposes. Think of qualified retirement accounts like 401(k)s or IRAs, or cash from permanent life insurance policies—these follow a first-in-first-out method, where you get your initial dollars back before touching gains.
Your cost basis is the total amount you paid for an investment, adjusted for things like stock dividends, splits, and commissions. You and your financial advisors need to track this cost basis carefully to identify any ROC payments. When you sell an investment for a gain, you report the capital gain on your tax return as the sale price minus the cost basis. If you receive an amount that's less than or equal to your cost basis, it's ROC, not a capital gain.
Examples and Special Cases
Some dividends from real estate investment trusts (REITs) count as ROC because they return your invested funds, and while they're not taxed, they do reduce your cost basis in the REIT.
Consider this example with stock splits: suppose you buy 100 shares of XYZ stock at $20 each, and there's a 2-for-1 split, so you now have 200 shares at $10 each. If you sell at $15 per share, the first $10 is ROC and not taxed, but the extra $5 per share is a capital gain you report on your taxes.
Factoring in Partnership Return of Capital
A partnership involves two or more people contributing assets to run a business and share profits, formalized by a partnership agreement. Calculating ROC in a partnership can be complex. Your interest in the partnership is tracked in a capital account, which increases with your contributions and share of profits, and decreases with withdrawals, guaranteed payments, and your share of losses. Withdrawals up to your capital account balance are ROC and not taxable. But once that balance is fully paid out, any additional payments become income and are taxed on your personal return.
Differences and Tax Implications
Return of capital is also known as a capital dividend, which is a payment from a company's paid-in capital or shareholders' equity to investors. Regular dividends, on the other hand, come from the company's earnings. ROC distributions aren't taxed, but once your adjusted cost basis hits zero, non-dividend distributions turn into taxable capital gains. Return on capital is the annual taxable return from your initial investment, while return of capital is how you recoup that initial investment.
The Bottom Line
When you get a return of capital, you're receiving back some or all of your investment in a stock or fund. It's easy to mix this up with dividends, but they work differently: ROC comes from paid-in capital or equity, while dividends come from earnings. These distributions aren't taxable, but they can lead to tax implications by creating additional realized capital gains.
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