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What is 'Return Of Capital'

Return of capital is a payment received from an investment that is not considered a taxable event and is not taxed as income. Instead, return of capital occurs when an investor receives a portion of his original investment, and these payments are not considered income or capital gains from the investment.

Note that a return of capital reduces an investor's adjusted cost basis. Once the stock's adjusted cost basis has been reduced to zero, any subsequent return will be taxable as a capital gain.

BREAKING DOWN 'Return Of Capital'

Cost basis is defined as an investor’s total cost paid for an investment, and cost basis for a stock is adjusted for stock dividends and stock splits, as well as for the cost of commissions to purchase the stock. It’s important for investors and financial advisors to track the cost basis of each investment so that any return of capital payments can be identified.

How Capital Gains Are Calculated

When an investor buys an investment and sells it for a gain, the taxpayer must report the capital gain on a personal tax return, and the sale price less the investment’s cost basis is the capital gain on sale. If an investor receives an amount that is less than or equal to the cost basis, the payment is a return of capital and not a capital gain.

Instances Where Stock Splits Impact Return of Capital

Assume, for example, that an investor buys 100 shares of XYZ common stock at $20 per share and the stock has a 2-for-1 stock split, so that the investor’s adjusted holdings total 200 shares at $10 per share. If the investor sells the shares for $15, the first $10 is considered a return of capital and is not taxed. The additional $5 per share is a capital gain and is reported on the personal tax return.

Factoring in Partnership Return of Capital

A partnership is defined as a business in which two or more people contribute assets and operate an entity to share in the profits. The parties create a partnership using a partnership agreement, though calculating return of capital for a partnership can be difficult.

A partner’s interest in a partnership is tracked in the partner’s capital account, and the account is increased by any cash or assets contributed by the partner, along with the partner’s share of profits. The partner’s interest is reduced by any withdrawals or guaranteed payments, and by the partner’s share of partnership losses. A withdrawal up to the partner’s capital account balance is considered a return of capital and is not a taxable event. Once the entire capital account balance is paid to the partner, however, any additional payments are considered income to the partner and are taxed on the partner’s personal tax return.

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