roc

Real estate investment trusts (REITs), mutual funds, master limited partnerships (MLPs) and other investments commonly make returns of capital. There are a few reasons why they do this.

With funds, ROC is usually done because their underlying investments have not generated the annual income necessary to make the expected dividend payments to investors in a year. This essentially forces the manager to dip into the fund/trust/partnership's principal to come up with the money.

With a trust, it's a different story. Trusts often have very high depreciation expenses. While these expenses affect net income, they do not affect the amount of cash available to the trust. When the trust distributes more than its net income, the excess portion of the distribution is considered return of capital.

Cash generated from the sale of capital assets can also constitutes a return of capital in the sense that the cash did not come in the entity's normal course of business and instead represents a portion of the original investment in the business.

Returns of capital are not considered income and are thus tax-exempt -- that is, until the returns of capital exceed the original investment. For example, if you invested $10 in Company XYZ and received a $5 return of capital after one year, that $5 payment would be tax-exempt. If, however, you received a $6 return in the second year, for a total of $11 in returns of capital, the amount that exceeds the original investment ($1 in this case) is taxed as ordinary income at your marginal tax rate.

A return of capital decreases the cost basis of an investment. If you invested $10 and then received a $1 return of capital, your cost basis becomes $9. This has important tax implications discussed below.

Returns of capital appear in Box 19, the "Distributions" section of IRS Schedule K-1, which MLPs must send to their limited partners every year.