What It Is:

Return of capital is a payment from a security to an investor representing the return of all or a portion of an original investment and thus decreasing the value of that investment.

How It Works/Example:

Real estate investment trusts (REITs), mutual funds, master limited partnerships (MLPs), and other investments commonly make returns of capital, and the biggest reason they do so is because their underlying investments have not generated the annual income necessary to make the expected dividend or distribution payments to investors in a year. This essentially forces the manager to dip into the fund/trust/partnership's principal to come up with the money. However, there are two other things that generate returns of capital: depreciation and asset sales.

Depreciation is a noncash expense, and the higher it is, the higher a REIT, MLP, or similar distribution is. This is because these entities must distribute most of the cash they generate, which is generally calculated by adding noncash expenses like depreciation back to net income. Cash generated from the sale of capital assets also constitutes a return of capital in the sense that the cash did not come in the entity's normal course of business and instead represents a portion of the original investment in the business.

Returns of capital are not considered income and are thus tax-exempt -- that is, until the returns of capital exceed the original investment. For example, if you invested $10 in Company XYZ and received a $5 return of capital after one year, that $5 payment would be tax-exempt. If, however, you received a $6 return in the second year, for a total of $11 in returns of capital, the amount that exceeds the original investment ($1 in this case) is taxed as a capital gains distribution.

A return of capital decreases the cost basis of an investment. If you invested $10 and then received a $1 return of capital, your cost basis becomes $9. This has important tax implications discussed below.

Returns of capital appear on IRS Form 1099-DIV, which issuers send to their investors every year. IRS Schedule K-1, which MLPs must send to their limited partners every year, discloses any returns of capital as well.

Why It Matters:

There are two significant attributes of returns of capital. First are the future tax effects. If, in our example above, you sell your Company XYZ investment after year one, when the basis has fallen to $5, the capital gains tax associated with the sale is based on the difference between $5 and the sale price. So even though you may have paid $10 for the investment, you calculate capital gains taxation as if you paid only $5. This can significantly increase your capital gains tax, but some investors find the cash inflow from the return of capital worth it.

Second, issuers sometimes make returns of capital to keep up the level of distributions shareholders have come to expect. If, for example, Company XYZ only generated enough revenue to pay a $3 per share dividend rather than the $5 per year the shareholders expect, it might make a payment in the form of a $3 per share taxable dividend and a $2 per share return of capital so that the shareholders will receive $5.

The tax effects of returns of capital can be particularly prickly for some investors, and they should consult with a qualified tax advisor to make the best decisions about the treatment of investment distributions.