Next, you need to look at your Form 1099 reports since the date of purchase and see if any of the dividends paid by the company were classified as "return of capital" payments for tax purposes. Also referred to as "return of principal" payments, these amounts reduce your cost basis.
Return of capital payments are often seen in the cases of utility stocks, real estate investment trusts, or corporations which are paying dividends in excess of their earnings and profits.
You are required to apply the return of capital to each tax lot separately. You cannot choose to apply it only to your high cost basis tax lots. You may end up with some tax lots where the cumulative return of capital payments exceed your original cost basis per share. In that case, you are required to recognize any excess return of capital payment for that tax lot as a capital gain distribution.
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Return of Capital Calculator
Even if a "return of capital" payment is not listed on your Form 1099, you may still have one! This situation may occur when you buy a stock between the record date and the ex-dividend date. For small dividends, you can ignore this aspect, but for large special dividends it is worthwhile to make the adjustment. For instance, look at the recent Warner Chilcott (Nasdaq:WCRX) $8.50 special dividend with a record date of 8/30/2010, a payable date of 9/8/2010, and an ex-date of 9/9/2010. Note that the ex-date was changed by the Nasdaq stock exchange from the normal ex-date of 8/28/2010 to 9/9/2010 so that the stock will trade with a "due bill" from 8/30/2010 through 9/8/2010. This was done because the dividend represents more than 25% of the stock price per share. It draws attention to the large upcoming dividend so that the market price will adjust to fairly reflect the appropriate value to the buyer and seller. The purchaser during the ten-day period due bill period can reduce his cost basis by the amount of the dividend he receives on 9/8/2010. If the broker/ dealer reports the payment as a taxable dividend rather than return of capital, the purchaser can attach a statement to his tax return to report an adjustment in the Form 1099-DIV taxable dividend amount to reclassify it as a return of capital and adjustment of basis.
Here is a detailed example:
You bought 500 shares of Servicemaster at $13.00 per share on 1/31/2006, for a total cost of $6,500.00.
On your Form 1099 report from your brokerage firm, you find that the following return of capital payments have been reported from Servicemaster:
For 2006: $200.00 ($0.40 per share) For 2007: $120.00 ($0.24 per share)
You did not pay any income taxes on the return of capital payments.
On 7/18/2007, you sold all of your Servicemaster shares for $7,780.00.
What is your cost basis and related gain or loss?
You do not have to declare a capital gain distribution for the return of capital payment because the cumulative amount of $0.64 per share is less than your cost basis per share of $13.00 for the one tax lot that you own.
Your new cost basis is your original purchase price of $6,500.00 less the return of capital payments of $200 and $120 received in 2006 and 2007. Thus, your adjusted cost basis is $6,180.00 and your capital gain is $1,600.00 ($7,780.00 less $6,180.00).
If you have multiple tax lots, apply the return of capital payment prorata according to the number of shares in each tax lot. Corporations pay dividends and return of capital payments equally to each share held on the record date.