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What is Return of Capital?
Return of capital refers to a return that an investor receives of the amount invested, and is excluded from the taxable income category. It takes place when an investor gets a percentage of his or her actual investment, and such proceeds are not included in the income or capital gains from the investment category.
It would be important to know that a return of capital decreases the adjusted cost basis of an investor. After the adjusted cost basis of the stock reaches zero, any following return will be treated as capital gains.
Important: Return of capital is different from return on capital that involves the rate of return received on the investment made, and comes under the taxable category.
A Little More on What is Return of Capital
An investor invests in order to receive a return at a later date. The initial amount or principal invested is called the cost basis. When the investor receives the principal amount back, it is known as a return on capital. As it excludes any profits or losses, it is not taxable. It is mostly like receiving your actual amount back. There are some investments that offer investors capital back prior to gaining any profits or losses for taxation. Qualified retirement plans such as 401(k) or IRA are fine examples of FIFO or first-in-first-out method where the person gets the dollar first prior to gaining profits.
Cost basis refers to the total amount that an investor contributes towards an investment. Adjustments can be made in case of stock dividends and stock splits, expense of commission for buying the stock. Financial advisors as well as investors should keep a record of the investment’s cost basis so as to ascertain the return of capital payments.
An investor who sells a stock, and earns profits thereon should report the capital gains while filing personal tax. Capital gain can be calculated by subtracting the cost basis of an investment from its sale price. If the amount received is equivalent or lower than the cost basis, that payment is a return of capital, rather than capital gain.
Key points to Remember
- Return of capital refers to the amount paid or return that an investor receives from an investment which is not taxable.
- Return of capital takes place when an investor obtains a specific proportion of actual investment, and such payments don’t make a part of income or capital gains.
- Some investments such as retirement accounts and long-term insurance policies get some capital back before anything else. One can expect receiving gains first from regular investment accounts.
Example of Stock Splits and Return of Capital
Let’s say an investor purchases 100 shares of ABC common stock for $20 per share. The stock offers a 2-for-1 stock split so as to make the adjusted holdings of investor for 200 shares at $10 for each share. When he sells shares at $15, the initial $10 will be treated as a return of capital and won’t be taxed. The remaining $5 per share will be considered a capital gain and will be recorded as personal tax return.
Factoring in Partnership Return of Capital
Partnership refers to a form of business where a minimum of two persons combine assets and do profit-sharing while operating the business. Parties formulate a partnership deed, and may find it difficult to calculate return of capital in a partnership agreement.
The capital account of the partner showcases the interest of a partner in a partnership firm. If any cash or assets are offered by a partner, it results in increase in capital account as well as the percentage of profits. The interest of partner can be decreased when any amount is withdrawn from the account as well as the losses incurred. Any withdrawal that is made up to the capital account amount of the partner is non-taxable and is treated as a return of capital. After the partner receives the total capital account balance, any excessive payments are treated as partner’s income and are taxable on the personal income tax return of the partner.