The universe of closed-end funds offers a range of choices for investors looking for high-yield investments. These funds use a variety of strategies to enhance the income to investors, and these strategies produce different types of income under the tax rules. It is possible for a portion of the dividends paid by a closed-end fund to be classified as return of capital.
Income, Dividends and Return of Capital Tax Treatment
Distributions received from a closed-end fund can be classified as ordinary income, qualified dividends, capital gains or return of capital. Each different type of distribution is reported and taxed differently on your income tax return. Many closed-end funds show the breakout of each dividend paid on a fund's Web page. On the year-end Form 1099-DIV from the closed-end fund, the total return of capital paid during the year is listed under "Nondividend distributions."
The portion of fund dividends classified as return of capital is considered to be a return of your investment in the fund. As a result, return of capital in closed end funds or any other funds is not taxable income. If a portion of the dividends you receive from a closed-end fund are classified as return of capital, the taxes due on that income will be less than if the full dividend amount was classified as ordinary income. On your annual income tax return, return of capital income is non-taxable income, providing a tax advantage to the income received.
The return of capital distribution you receive from a closed-end fund must be used to reduce the cost basis of the fund investment. For example, you purchased $1,000 worth of a closed-end fund and received $50 in return of capital as part of the dividends received. The $50 is subtracted from the $1,000, giving you a new cost basis of $950. If you sell the closed-end fund shares for more than the $950 cost basis, the extra money is a taxable capital gain. As a result, return of capital is not truly tax-free income. Taxes on the return of capital are delayed until you sell the closed-end fund shares.
Risks from Decreasing Tax Basis
If you own a closed-end fund that makes return of capital dividend payments long enough, it is possible for your tax basis to go to zero. If your cost basis in a closed-end fund investment reaches zero, the return of capital received each year must be reported as a taxable capital gain. The type of gain – short or long term – depends on how long you have owned the fund shares. With the zero cost basis, if you sell the fund shares, the entire proceeds of the sale would be a taxable capital gain.