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.
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 (two days before the record date) to 9/9/2010 (the day after the pay date) so
that the stock will trade with a "due bill" from 8/30/2010 through 9/8/2010. This was done
according to stock exchange rules because the dividend represented 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 reflect fairly 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. The theory is that the buyer of a stock
with a large extraordinary dividend due bill attached actually acquired two assets: the
underlying stock plus the right to the extraordinary distribution. The receipt of the large
dividend is thus a return of capital because the market price of the stock ordinary falls by
the dividend amount on the ex-date to reflect only the value of the underlying stock. The
receipt of the dividend is essentially the return of the buyer's own money.
The broker/dealer should not report the payment as a taxable dividend on your Form 1099,
since it should be taxed to the previous owner of the stock on the record date. If the
broker/dealer reports the payment to you as a taxable dividend rather than return of capital,
you can attach an explanation statement to your tax return to report a reduction in the Form
1099-DIV taxable dividend amount and to reclassify it as a return of capital and adjustment
Further discussion of the Warner-Chilcott extraordinary dividend can be found in
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.
It is important to consult your Form 1099 report at year-end for the final status of payments received and not just go by the monthly account statement. Payments are often recorded as ordinary dividends during the year and not reclassified to return of capital payments until the end of the year when corporations report the tax status of dividends to the broker/dealer. The tax treatment is often not known until after year end when the tax analysis of the accumulated earnings and profits of the corporation has been completed. This often results in late reports and amended Form 1099 reports. Don't blame your broker! They are required to issue an amended Form 1099-DIV report to you whenever a corporation reports a change in the tax status of its dividends.