In this article, we’ll examine the return of capital distribution, why and where it’s made, and how it impacts you as an investor.

A return of capital distribution, sometimes called a non-dividend distribution, comes from when the fund returns a portion of an investor’s original investment. It often occurs when a fund makes a distribution larger than it generates in income. Any excess that gets distributed by the fund is categorized as a return of capital. A return of capital is a non-taxable event and is not considered either a dividend or capital gain distribution.

A return of capital distribution reduces the tax basis of the investment and can impact capital gains taxes when the investors finally sell their shares.

For more information on the taxation of mutual funds, take a look at our article on How Mutual Funds Are Taxed.

Funds that return capital to shareholders are simply returning a portion of an investor’s original investment. The return of capital is non-taxable, but the distribution itself does affect the taxes paid on future capital gains as explained in the example below.

Consider an investor that purchases 100 shares of XYZ Fund for $10 per share. One year later, the fund makes a $1-per-share return of capital distribution. The cost basis for the investment then drops to $9 per share. If the investor goes on to sell his shares for $11 per share, the trade will generate a $2-per-share capital gain. Since the cost basis of the investment is reduced, returns of capital can result in larger capital gains or smaller capital losses when a sale of shares is made. They may also improve the tax efficiency of the investment as long-term gains are taxed at the more advantageous capital gains rate if held for more than one year.

At tax time, shareholders who receive a return of capital distribution will receive a 1099-DIV form from the fund’s provider. Return of capital shows up under the “Non-Dividend Distributions” column on the form.

In addition to mutual funds, ETFs also provide distributions. Read about it in our article on ETF Distributions and Capital Gains.

Return of capital distributions occur most frequently with real estate investment trusts (REITs) and master limited partnerships (MLPs). These products may return capital to shareholders to account for depreciation and drawdown of assets. Depreciation, for example, is a non-cash expense that impacts net income but not available cash. A return of capital distribution can help level out this imbalance.

Return of capital may also occur in managed payout funds. These funds look to make fixed monthly distributions to shareholders. If the fund is unable to generate enough income to make the full monthly payment, a return of capital distribution may be made to make up any shortfall.

With our Dividend Reinvestment Calculator, find out how much you can make investing in dividend-paying stocks.

Return of capital distributions are relatively uncommon for mutual funds. Here are four funds that have made return of capital distributions recently. Click on the ticker for more information on the distribution analysis offered for each fund.

Return of capital distributions are frequently misunderstood. Unless you own shares of a particular group of mutual funds, you’ll likely never see one. Since they can have some important tax implications, it’s essential to get a grasp of what they mean for investors so you’re not unnecessarily sending more money than you owe to Uncle Sam.

To learn more about how mutual fund distributions are taxed, check out the Taxation section on our website.