What is return of capital and how it helps you save taxes?

Return Of Capital

When you invest in certain assets, you may come across a term called “Return of Capital” (ROC). It’s an often-misunderstood concept that can have significant implications for your investment strategy and tax planning. If you’re a U.S. investor, understanding ROC is essential for making informed decisions and potentially saving on taxes. Let’s break it down in simple terms to help you grasp its benefits and limitations.

Table of contents

  1. What is return of capital?
  2. How is the return of capital taxed?
  3. Potential benefits of ROC
  4. Return of capital vs. Dividends
  5. How to incorporate ROC into your investment strategy?
  6. How to track and report return of capital?
  7. The bottom line

What is return of capital?

Return of Capital refers to the portion of a distribution from an investment that is not considered taxable income. Instead of representing earnings or profits, ROC is a return of the original amount you invested. This typically happens when an investment pays you more than the income it generated, dipping into the principal amount.

Think of it as getting some of your money back rather than earning additional income. Because ROC isn’t classified as income, it’s generally not subject to immediate taxes. Instead, it reduces your cost basis in the investment. Once your cost basis reaches zero, any further ROC is taxed as a capital gain.

Quick tip: ROC is different from return on capital, which comes in the form of dividends or other returns that don’t diminish your principal investment. While you don’t have to pay income tax on ROC, you may have to pay taxes on returns on capital.

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How is the return of capital taxed?

Return of capital (ROC) is not taxed because it represents a repayment of your initial investment rather than income or profit. Like receiving a refund for a product, ROC does not affect your taxable income.

When you sell an asset for a gain, you must report the capital gains on your tax return. Capital gains are calculated by subtracting the investment’s cost basis from the sale price. If the result is less than or equal to the cost basis, it is considered a return of capital rather than a capital gain. Depreciation can also impact how capital gains are calculated.

Capital gains are taxed based on how long the asset was held:

  • Short-term capital gains: Profits from assets held for less than a year, typically taxed at higher rates.
  • Long-term capital gains: Profits from assets held for more than a year, taxed at lower rates.

Quick Tip: If you sell stock after a stock split, part of the income may be taxable. The amount considered ROC reduces your cost basis, while any profit is taxed as a capital gain.

Example of ROC work

  • Let’s illustrate this with an example:

    Suppose you purchased 100 shares of a stock for $1,000, giving you a cost basis of $10 per share. Over time, the company pays you a total of $200 as Return of Capital distributions. This $200 is not taxed immediately but reduces your cost basis to $800, or $8 per share. If you later sell the shares for $1,200, your capital gain would be $400 ($1,200 sale price – $800 adjusted cost basis).

  • The key takeaway here is that ROC shifts your tax liability to the future, potentially allowing you to defer taxes until you sell the investment.

Potential benefits of ROC

ROC provides several tax advantages that can make it a valuable part of your investment strategy:

1. Tax deferral

The primary benefit of ROC is that it allows you to defer taxes. Unlike dividends or interest, which are typically taxed in the year they’re received, ROC reduces your cost basis without immediate tax consequences. This deferral can be particularly advantageous if you’re in a high-income tax bracket now but expect to be in a lower bracket later.

2. Lower tax rates on capital gains

When you eventually sell an investment that’s distributed ROC, the gains are taxed at capital gains rates, which are often lower than ordinary income tax rates. Long-term capital gains (for assets held over a year) are especially favorable.

3. Potential for strategic tax planning

By strategically holding investments that distribute ROC, you can manage your taxable income and adjust your tax liability to align with your financial goals. For example, ROC distributions could allow you to realize gains during a year when you have offsetting losses.

4. No double taxation

Since ROC isn’t classified as income, you avoid being taxed on the same money twice. This is particularly helpful for investments like REITs, where earnings might otherwise be taxed at both the corporate and individual levels.

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Return of capital vs. Dividends

Return of capital and dividends are types of distributions. Sometimes, companies will pay out distributions that are both ROC and dividends. Unlike ROC, dividends are a kind of return on capital.

Return of capitalDividends
Distributions occur when your principal is returned.Dividend stocks do not return part of the principal. Instead, they share profits with shareholders as dividends
Ownership is diminished or reduced completely.Ownership is not affected but returns may result in an adjusted cost basis.
Not considered investment income for tax purposesConsidered taxable income

Quick tip:

  • When an investor receives a Form 1099-DIV,
    they may find out that a distribution for their original investment was split between ROC and dividends. In this case, the investor would pay taxes on the dividends, but not on the ROC. The cost basis for the stock will also be adjusted down for the ROC.

How to incorporate ROC into your investment strategy?

While Return of Capital can be beneficial, it’s important to use it strategically:

1. Diversify your portfolio

Don’t rely solely on investments that distribute ROC. Balance your portfolio with other assets to maintain a healthy mix of income and growth.

2. Understand the source of ROC

Research why an investment is returning capital. Is it due to depreciation, or is the company struggling? This understanding will help you make better decisions.

3. Consult a tax professional

Navigating ROC’s tax implications can be complex. A financial advisor or tax professional can help you maximize its benefits while avoiding pitfalls.

How to track and report return of capital?

As a U.S. investor, you’ll receive Form 1099-DIV from your brokerage at the end of each tax year. This form will specify how much of your distributions are classified as ROC. Public.com, as your brokerage, ensures that these details are clearly outlined, simplifying your tax reporting process. By maintaining accurate records, you can confidently adjust your cost basis and report gains or losses correctly.

The bottom line

Understanding the return of capital (ROC) is essential for making informed investment decisions and managing your portfolio effectively. While ROC might initially seem complex, it’s simply a way for companies to return part of your invested principal, impacting both your cash flow and cost basis. By knowing how ROC works and its implications for taxes and overall returns, you can better evaluate its role in your investments.

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Frequently asked questions

What is the difference between return of capital and a stock buyback?

Stock buybacks occur when a company repurchases its shares. They often result in a return of capital.

What happens if my cost basis reaches zero?

Once your cost basis is reduced to zero, any further ROC distributions are taxed as capital gains.

How does return of capital impact ownership?

Return of Capital (ROC) reduces or terminates ownership of an asset because the returned capital is no longer part of the investment. In some cases, ownership may be completely eliminated, leaving the investor without control over the asset.

What should I do if my ownership is reduced due to ROC?

If ownership is significantly reduced or terminated, investors may need to adjust their accounting approach. For example, they might switch from the equity method to the cost method for tracking their investment. Consulting with a financial advisor can help in managing such changes.

How does ROC affect my portfolio?

ROC can lower your stake in an asset while providing tax-free cash distributions. Although the distributions are not taxable, they reduce the cost basis of your investment, which may affect future capital gains calculations.

Where can I learn about ROC events and their impact on my portfolio?

To better understand ROC events like stock splits or share buybacks, you can:

  • Use Public’s social investing features to connect with other investors for insights.
  • Tune into Public Live for real-time expert commentary and updates on how ROC affects investments.
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