If you make money from an investment, you have to pay capital gains tax. However, understanding how to calculate your capital gains tax can be confusing, so confusing that the Internal Revenue Service (IRS) estimates the government loses about $345 billion annually due to errors in capital gains tax reporting. Understanding how a return of principal reduces your cost basis can help you avoid errors when you report your capital gains.
Return of Principal Definition
More commonly called a return of capital, a return of principal is a payment from an investment, trust or other security that is not a result of income. Instead, the payment is a portion of the money you originally invested in the security. A common example of a return of principal occurs in the case of mutual funds. Mutual funds typically make returns of principal when the income generated from the investment is not enough to satisfy investors' expectations. Fund managers sometimes distribute money earned through investment along with a partial return of principal to meet those expectations.
Cost Basis Definition
Generally, the cost basis for a capital asset is the original purchase price plus improvements. In the case of stocks, the cost basis is what you originally paid for the stock plus fees you paid the broker.
Calculating Capital Gains and Losses
If the money you receive from selling your capital asset is greater than your cost basis, you have a capital gain. If it your cost basis is greater, you have a capital loss. Subtract the smaller number from the greater to find the value of your loss or gain. While you must pay tax on all gains, you can only claim deductions on business-related losses.
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Return of Principal and Lowering Cost Basis
When you receive a return of principal payment, that payment lowers your cost basis, but it cannot push the cost basis below zero. For example, if you paid $20 for a mutual fund and received a return of principal of $5, lower your cost basis by $5. Your new cost basis is $15.
The lower your cost basis, the easier it is for you to earn a capital gain, which means you will owe capital gains tax. For example, imagine you invest $20 in a mutual fund in 2011. Your stock does not do as well as expected, so your fund's manager distributes a return of principal payment. You receive $5 from the stock's earnings and $5 return of principal. You have a capital loss. In 2012, your stock does better. It earns $16. If you had not lowered your cost basis, you could have still reported a capital loss. However, your cost basis is now $15, so you have a capital gain.