When you choose to invest in various funds or partnerships or trusts, you need to be aware of the terms and situations in which you may have money returned to you. Sometimes, that will be in the form of profit distributed among shareholders (or partners or trustholders). Other times, you may receive what is called “Return of Capital,” or ROC. Let’s take a quick look at what this means for you as a shareholder and how it differs from other financial terms.
What is Return of Capital?
In short, return of capital occurs when an investor receives part of his original investment back. This payment is not considered income or capital gain. It is not taken from net income. As such, it is not considered a taxable event and won’t be taxed as income – unless the capital received exceeds the original investment for some reason. Whatever return of capital occurs, it decreases the investor’s cost basis for the investment.
When Does Return of Capital Occur?
Return of capital happens in a few situations that differ based on the type of fund.
– Funds: ROC typically happens when the underlying investments haven’t generated enough income to fulfill the needed dividend payments for the year. Essentially, the fund manager has to withdraw the remainder from the fund’s principal to make the payments.
– Trusts: When a trust distributes more than its net income, the excess portion is considered ROC. This happens because of the high depreciation expenses incurred by a trust, which impact the net income, but not the amount of cash available to the trust.
Return of capital can impact a variety of tax effects, and if you’re concerned about an ROC event impacting yours, you should likely consult with a professional.
How Does it Differ from Dividend and Interest Payments?
Knowing the difference between dividends, interest payments and return of capital is important. The biggest difference is where the money comes from. In most cases, the money that is being paid to shareholders should come from the profits of the company. Dividends can vary, since they may be given as cash or as stock. However, with return of capital, the money is not drawn from profits.
Understanding the situations and impacts of ROC are important for any shareholders. If you ever receive ROC, be sure to know how it will impact your taxes – since it can get a bit complicated.