Return of Capital vs Ordinary Dividend

An ordinary dividend is a payout of the company's actual profits — money the business earned and is distributing to shareholders, and it is typically taxed as dividend income in the year it's paid. A return of capital is different: it's a cash distribution that isn't backed by current earnings at all, so instead of being treated as income, it is treated as giving you back part of the money you originally invested. Rather than being taxed immediately, a return of capital reduces your "cost basis" — the reference price used to calculate gain or loss when you eventually sell.

For example, suppose you bought a real estate investment trust (REIT) at $50 per share, and it pays out $3 per share, of which the fund classifies $2 as an ordinary dividend and $1 as a return of capital. You owe tax on the $2 dividend now, but the $1 simply lowers your cost basis to $49. If you later sell at $55, your taxable gain is $55 − $49 = $6 instead of $5 — the return-of-capital portion isn't tax-free forever, it's tax-deferred until sale, and it makes the eventual gain slightly larger.

This distinction matters most for structures that regularly distribute more cash than they earn in accounting profit, like REITs, MLPs, and some closed-end funds. Their distributions are frequently split between ordinary income, capital gains, and return of capital, and the split is only known after the fact via a tax statement, not at the time of payment. A high dividend yield can be misleading if a large share of it is really the fund handing your own capital back to you rather than genuine income.