Return of Capital in a Fund: Effect on Tax Cost
Return of capital is not income: it reduces the cost base and increases the future gain.
In this article
Return of capital looks attractive: a distribution that is untaxed on receipt. In fact it is your own money coming back. It is not taxed because it is not income, and each payment reduces the cost base of your units by the same amount. The tax is not cancelled, it is deferred. At sale, the gain is calculated on the reduced cost, and what seemed exempt gets paid as a larger gain. So you need to track it: reconcile the tax slip with the statements every year, then subtract the return-of-capital portion from the cost in your register. Otherwise the figure used at sale will be wrong. A high distribution also calls for a sustainability check. A fund that keeps paying out more than it earns is returning capital, and the prospectus tells you more than the posted rate. This article explains the mechanics, the upkeep of the register and how to read distributions, so you can tell a real return from an apparent one.
Find the line on the tax slip
A fund distribution breaks down into several types of income. Return of capital is one of them, on a separate line of the annual slip. That amount is not taxable in the year you receive it, which makes it look advantageous. But it is not a return. It is a repayment of part of your own capital, or of an amount the fund did not earn that year. Read the slip line by line instead of looking only at the total distributed. That shows what the fund actually paid out.
Reduce the cost base after each payment
Every dollar of return of capital reduces the adjusted cost base of the units you hold by one dollar. The reduction is mandatory and cumulative. A fund that pays $300 of return of capital a year for ten years lowers the tax cost by $3,000, and no statement shows that adjusted cost. Your own register is the only place where the calculation exists. Neglecting the reduction is like forgetting reinvested distributions, but in the other direction: the gain declared at sale will be too low, and the correction comes later.
Understand deferral rather than exemption
Return of capital does not remove the tax, it moves it. The reduced cost base produces a larger capital gain at sale, and the tax is paid then. The real advantage is a deferral, which has value, plus the fact that a capital gain is taxed more favourably than interest income. One special case deserves attention. When cumulative returns of capital bring the cost base to zero, later payments become immediately taxable as capital gains. This surprises long-time holders.
Reconcile slips and statements every year
The annual reconciliation compares the tax slip with the broker's statements. The sum of distributions received must match, and the portion classified as return of capital must appear in the cost base register. Do this each spring, at filing time. It takes fifteen minutes per fund and spares you a laborious reconstruction at sale. Keep the slips for as long as you hold the investment, plus the usual retention period after the sale. In an audit, they are what supports your tax cost.
Quebec scenario
A dentist in Trois-Rivières holds a real-estate fund that pays 6% a year. For three years he thought of those payments as rent. On the March tax slip, more than half the distributions show up as return of capital. He had assumed that category meant tax-free income, in other words a gift. His accountant explains the mechanics in three lines. Return of capital is not a return. It is part of his own money coming back, untaxed on receipt because it is not income. Each payment reduces the cost base of his units by the same amount. His $25,000 investment now has a tax cost of $21,400. So he has to track every distribution and reconcile the slips with the statements, year after year. The bill arrives at sale: the capital gain is calculated on the reduced cost. The tax avoided today is paid then, as a larger gain. It is a deferral, not an exemption. A high distribution also calls for a sustainability check. A fund that pays out more than it earns is returning capital, by definition. The answer is in the prospectus, not the brochure. The dentist keeps the fund, knowingly this time. His cost-base file has one more column: he enters January's distributions before the slip even arrives. He has learned that tax cost has to be kept current, or it has to be rebuilt later, with a lot of effort.
Checklist
- Read the distributions' composition on the slip
- Identify the return-of-capital portion
- Subtract that portion from the cost base
- Reconcile slip and statements each year
- Understand the deferral, not an exemption
- Expect the larger gain at sale
- Check the distribution's sustainability in the prospectus
- Distinguish real return from your own money returning
- Keep the register current continuously
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