Capital gains are partial or total returns on investments you make in a stock or fund. These distributions are not subject to taxes but may have tax implications.
Definition of Capital Gains
Capital gains, also known as “ROC”, are partial or total returns on an investment in a stock or fund. ROC distributions are not considered dividends although ROC can be included in a fund distribution because ROC is the original amount you invested. While the fund provides estimates for tax responsibility throughout the year, the 1099-DIV form sent by the fund at the end of the year will show the exact amount of ROC you received during the year.
How do Capital Gains Work?
Suppose you buy 100 shares of a fund at a price of $10 per share. Your initial purchase cost is $1,000 (100 × 10), which makes your initial cost per share $10 ($1,000/100). If you buy an additional 100 shares at a price of $12 per share, you will now spend $2,200 (100 × 10) + (100 × 12) to buy 200 shares. Your total basis cost will now be $11 ($2,200/200).
Now, suppose the fund pays you a distribution of $4 per share, resulting in a payment of $800 (200 shares × 4) at the end of the year. When you receive your 1099-DIV form, you find out that $3 of the distribution came from income and interest earned by the fund and $1 was ROC.
Since $1 of your annual per-share distribution was ROC, your adjusted cost basis decreases from $11 to $10. Because your cost basis has decreased by $1, if you sell your shares for a profit, your realized capital gains will increase by $1.
Tax Implications
Capital gains distributions are not subject to taxes, but they have tax implications because they may generate additional realized capital gains. Selling a share at $11 when your basis cost is $10 will result in a capital gain of $1. But if your ROC was $2, then your capital gain per share would be $3:
Fund without ROC: Purchase price $10, capital gains $0, Selling price $11, Capital gains liability $1
Fund with ROC: Purchase price $10, capital gains $2, Selling price $11, Capital gains liability $3
The IRS expects you to know your total capital gains based not only on the difference between your purchase and selling prices but also on your capital gains.
What Does This Mean for Individual Investors?
Being aware of how capital gains work can help you understand how capital gains can affect you. When you sell your shares for more than your cost basis, more of that money will be considered capital gains compared to if you had not received a ROC distribution.
Although this may seem negative, capital gains provide you with an opportunity to earn tax-free monthly cash flow, and you can defer capital gains taxes until you sell your shares.
After the adjusted cost basis for a share is reduced to zero, any additional non-dividend distribution becomes taxable capital gains that need to be reported.
Return
Capital Gains vs. Dividends
While capital return distributions may seem like paid dividends, these distributions can have different implications.
Capital return distributions occur when part or all of your initial investment is returned. Dividends are paid out of the company’s earnings and profits. Capital return reduces your adjusted cost basis in the stock. The dividend payer must specify each type and amount of distribution to the investor so they can report it for tax purposes using Form 1099-DIV.
If you’re uncertain whether a distribution is a standard dividend or a capital return, you can review the guidelines issued by the IRS on how and when each occurs.
Key Takeaways
Capital return is relatively common in mutual fund investing. When someone receives a capital return, they are recovering some or all of their investment in a company or fund. It can be easy to confuse dividends with capital returns, but these two types of distributions operate in different ways.
How Does Capital Return Affect My Stock Ownership?
When you receive a capital return, you are recovering part or all of your investment in the company’s stock and that amount is no longer invested.
How is Capital Return Taxed?
Although capital return distributions are currently not taxable, once your adjusted cost basis in the stock is reduced to zero, any distribution other than a dividend will be considered taxable capital gain.
What is a Normal Rate of Return for Capital Return?
There is no single “normal” rate of return on capital that investors can expect, as net asset value and total return on investment as well as distribution rate can differently affect the rate of return.
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Source: https://www.thebalancemoney.com/what-is-return-of-capital-5190393
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