7945 / How is a return of capital taxed?

A distribution from a mutual fund that does not come from its earnings is a return of capital distribution (sometimes incorrectly referred to as a “nontaxable dividend” or “tax-free dividend”). These often occur when the fund is liquidating. The shareholder treats the return of capital as nontaxable to the extent of tax basis in the shares. Any excess over the shareholder’s basis is treated as a capital gain, which will be long-term or short-term depending on how long the shareholder held the mutual fund shares with respect to which the distribution was made. The shareholder must also reduce tax basis (but not below zero) in those shares by the amount of the return of capital distribution.¹ See Q 702 for the treatment of capital gain.

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1.  IRC § 301(c); See Rev. Rul. 57-421, 1957-2 CB 367; IRS Pub. 550.

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