What is Return of Capital? How can it help you save taxes?

Return of capital (ROC) occurs when investors receive part of their principal back from an investment. Much like a refund for a purchase, ROC is simply a return of an initial investment and is therefore not taxable.

There are a variety of situations where ROC may occur, including during stock splits, share buybacks, or as a result of investing in a Real Estate Investment Trust. Understanding why ROC occurs and how it differs from taxable distributions is essential for making sound investing decisions.

Table of Contents:

  1. What is Return of Capital?
  2. Examples of Return of Capital
  3. Return of Capital vs. Dividends
  4. How is Return of Capital Taxed?
  5. How Return of Capital Impacts Ownership
  6. What Does ROC Mean for my Portfolio?
  7. Frequently asked Questions

What is Return of Capital?

Return of capital, also called ROC, happens when an investor receives part of their invested capital back.

Money put into an asset is known as the principal. Investors want this principal to generate a return. This amount of this return is in addition to what is called the cost basis, or what the investment originally cost the investor. Sometimes, the principal is returned to the investor without any returns. That money is no longer invested, and the investor receives their money back – this reduces the original cost basis

It’s helpful to think of ROC like a refund for a purchase. After you receive a refund, you don’t own the product anymore but you do get your money back. Even though you get money back for a refund, you don’t have to pay taxes on that amount. ROC is similarly tax-free, since it doesn’t include gains or losses.

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.

Examples of Return of Capital

There are several scenarios where an investor may receive a return of capital. These include stock splits, distributions for partnerships, and stock buybacks. Returns of capital are also popular in mutual funds and Real Estate Investment Trusts (REITs).

Stock Splits

Stock splits occur when a company inflates the number of shares in order to increase liquidity. The most common ratios are 2-for-1, which means that each share will be split into two shares, and 3-for-1, which means that each share will be split into three shares.

If investors choose to sell a stock after a split, they may receive a return of capital. Let’s say an investor bought a single common stock at $100 per share and the stock then has a 2-for-1 split. That investor now has 2 shares at $50 each. If that investor sells one of those shares for $60, the first $50 is considered a return of capital and is not taxed. The remaining $10 is reported as capital gains.

Distributions for Partnerships

Partnerships can lead to complicated return of capital situations. Partnerships are businesses where two or more individuals have contributed assets and have the right to share the resulting profits.

Each partner has a capital account balance that is equal to their contributions to the partnership. Distributions up to the balance amount are considered return of capital and are therefore exempt from taxes. Anything above that amount is considered income and is taxed accordingly by the IRS.

Stock Buybacks

Stock buybacks occur when a company repurchases shares from the marketplace. This can increase the price of shares and increase the ownership stakes of existing investors. In many cases, these buybacks increase ROC for investors who sell the stock because they result in a total return of capital. Public Premium’s advanced insights from Morningstar can help investors find companies that are planning to initiate a buyback.

Real Estate Investment Trusts

Investors in REITs may find that they receive a significant return of capital from these funds.

These funds purchase real estate assets with the goal of generating income for shareholders. REITs are also legally required to distribute 90% of their taxable income to shareholders in the form of dividends. When dividends exceed a REIT’s income, the distributions are classified as a return of capital. ROC distributions are not taxed until the shares in the REIT are sold by the investor.

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 Capital Dividends
Distributions occur when your principal is returned. Doesn’t involve returning part of the principal.

Instead, companies return part of their profit to the shareholder. Companies that pay out dividends are known as dividend stocks.

Ownership is diminished or reduced completely. Ownership isn’t affected but returns may result in an adjusted cost basis.
Not considered investment income for tax purposes Considered 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 is Return of Capital Taxed?

Return of capital is not taxed because the investor simply receives a return from the previous investment. Much like a refund for a product, the investor’s taxable income is not affected by return of capital.

When investors sell an asset for a gain, they have to report those capital gains on their tax return and may need to pay capital gains tax. Capital gains are determined 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, not capital gains. Depreciation can also affect capital gains.

Capital gains are taxed differently depending on whether they are short-term or long-term capital gains. Short-term capital gains are defined as profits from assets held for less than a year, while long-term capital gains are profits from assets held more than a year. Usually, short-term capital gains are taxed at a higher rate than long-term capital gains.

Quick Tip: In some cases, investors may be liable for capital gains and also receive a return of capital. If investors sells a stock following a stock split, part of the income from a sale may be taxable. That’s because the initial amount would be considered a return of capital, while the profit would be taxed as capital gains.

How Return of Capital Impacts Ownership

After capital is returned to the owner, the ownership of that asset is reduced or terminated. Since the investor received cash back for the investment, that money is no longer invested.

In some cases, the ownership is reduced entirely and the investor no longer has control over the asset. When this occurs, investors often need to adjust their accounting approach from the equity method to the cost method. If you have questions about how ROC from a company could affect your portfolio, Public’s Town Halls will help you connect with company leaders who can answer your questions.

What Does ROC Mean for my Portfolio?

Return of capital can decrease your ownership of a certain asset or terminate your ownership entirely. At the same time, ROC distributions are not taxable because they are simply returning an investment that was already made.

If you’re unsure about what return of capital means for your portfolio, Public’s social investing feature can help you find like-minded investors who are in a similar position. And if you want to follow ROC events like stock splits or share buybacks as they occur, tune in to Public Live for up-to-the-minute commentary from industry experts.

Frequently asked questions

How do you account for return of capital?

Return of capital may require investors to adjust their accounting approach from the equity method to the cost method.

Is return of capital a good thing?

Return of capital reduces an investor’s stake in an asset, but also offers a tax-free return of an investment.

What is the difference between return of capital and a dividend?

Both are types of distributions. ROC is a return of the principal, which is not taxable. Dividends are distributions of a share of a company’s profit, which are taxable.

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.

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