Is return of capital taxable?

Not in the year you receive it, as long as your cost basis is above zero. It reduces that basis dollar for dollar, which raises the capital gain when you sell. After the basis is used up, additional distributions of this kind count as capital gains when paid.

Why does my 1099-DIV show a different amount than my monthly statements?

Funds and REITs often can't say how much of a distribution was income and how much was capital until their fiscal year closes. During the year the statement may label every payment a dividend; the 1099-DIV then splits the total into ordinary dividends, capital gain distributions and nondividend distributions.

Return of Capital: The Distribution That Lowers Your Cost Basis

Box 3 on Form 1099-DIV is labeled “Nondividend distributions.” Plenty of holders skip it. The money arrived looking like any other dividend, and the monthly statement probably called it one. It wasn’t. The amount in box 3 is the part the payer has classified as your own capital coming back, and the IRS treats it as a reduction in what you paid for the shares.

What happens to your basis

A return of capital isn’t taxed when you receive it. It lowers your cost basis by the same amount. The tax comes later, when you sell, as a larger gain.

The $100 you received shows up again as $100 of extra gain. Nothing escaped tax. It was deferred. Whether the gain on sale is short-term or long-term depends on how long you held the shares, with the one-year holding period as the dividing line. Situations differ; a tax preparer can say how it applies to yours.

When basis hits zero

Returns of capital can keep coming. Each one takes the basis lower. Eventually there’s nothing left to reduce, and from that point on every further dollar the fund classifies as return of capital is taxed as a capital gain in the year it lands in your account, even though you haven’t sold a single share.

Take the same 100 shares. Suppose the return of capital adds up to $2,000 over the years. Basis: zero. The next $100 of return of capital is a $100 capital gain that year, and when you eventually sell the shares the entire sale price is gain, which surprises holders who assumed the long run of untaxed payments meant the tax had simply gone away.

Where you’ll see it

Some funds and real estate investment trusts pay it often. Their payouts can run ahead of their taxable earnings for the year. The fund reports the character of its distributions after the year ends. So the split between ordinary dividends, capital gain distributions and return of capital appears on the 1099-DIV, sometimes in a corrected form issued later, and a statement’s running “dividend income” figure during the year may overstate what is really income.

Headline yield and the part that is income

A payout rate quoted on a fund’s page divides every dollar distributed by the share price, whatever the dollar’s source. Split it before trusting it.

The 6% is real cash. Just 3.5 points of it is income the fund earned for you. The rest is your own capital handed back, which also shrinks the base that future distributions are paid on if the fund has to sell assets to fund them, so a steady headline rate can sit on top of a slowly draining pool.

What people get wrong

Counting return of capital as yield. A high payout that is partly your money coming back is a smaller return than it looks, a gap worth checking with the dividend income calculator before you compare it to a bond.
Thinking it’s tax-free. Deferred.
Losing track of adjusted basis across many years of distributions.
Assuming a margin loan changes any of this. It doesn’t. Borrowed money raises separate questions, covered in collecting dividends on stock bought on margin.

Cost basis is what you paid, adjusted for events like this. A capital gain or loss is the sale price minus that basis. Losses carry their own rules for offsetting gains and income, including the IRS limit of $3,000 a year against ordinary income, with the rest carried forward. The case that dividend stocks are not bond substitutes rests partly on the gap between a payout and a return.