Quick Explainer, Return of Capital

There is a misconception among investors that distribution* is yield*. When a fund offers a high distribution rate, that’s just how much is being paid out, not what it’s being paid from. What a distribution is actually paid from can be a mix of income, realized gains, and return of capital.

Our definition of return of capital is:

Return of Capital: A distribution from an investment that is treated as a return of the investor's original investment rather than as taxable income. It reduces the investor's cost basis in the security they are holding, which can affect the tax treatment of any future sale.

That return-of-capital portion isn't taxed the year you receive it. Instead, it lowers your cost basis. For tax purposes, cost basis is the price you paid for the asset.

As an example of how your cost basis could be adjusted, assume you buy a fund at $20 and receive $1 of return of capital in a distribution. Your cost basis drops to $19. 

Now, this is the part most investors can miss. Deferred taxes still come due.

When you do sell an asset with a lower cost basis, you’ll have a larger gain (or smaller lose). Further, if your cost basis hits zero any more return of capital will get taxed as a capital gain.

Return of capital can show up for very different reasons. The distribution disclosures alone won't tell you which one you're looking at. Some funds generate it for routine tax and accounting reasons while the fund's value holds steady or grows. Option-income and pipeline strategies often work this way. This is sometimes called constructive return of capital, because the money coming back is funded by real gains.

Other funds pay out more than they earn. To cover the distribution, the fund sells down its own assets, so the payout looks generous while the fund's net asset value* (NAV) quietly shrinks. This is destructive return of capital, and it amounts to handing investors back their own principal.

Telling the two apart comes down to total return rather than the distribution rate. If a fund's NAV holds up over time while it pays return of capital, the capital is coming from gains. If the NAV keeps sliding, part of that payout is your own money. A fund's 19(a) notice estimates where a distribution comes from, and the year-end 1099-DIV is the official record.

The distribution rate lets you know the size of a payout. Looking at the distribution sources can tell you if the payout can last without eroding the NAV. Two ETFs could be running very different strategies but still advertising a similar distribution rate. Return of capital is often what separates them.