This is an interesting one. I’ll explain it in the same chronology as I discovered it.
When you own a REIT, one of the things you’ll notice is that your dividend isn’t wholly taxable (at least, not taxable at the point you receive the dividend). That’s because part of your dividend is “Return on Investment” (which is taxed) and part is “Return of Capital” (which is not taxed, at least, not yet). The deal is this: if the REIT issues a dividend that exceeds its taxable income (because of depreciation, etc), then that portion of the dividend that exceeds the taxable income is considered “Return of Capital.” Hmm, I thought. Does this mean that the REIT is just eating away at itself so it can generate an abnormally high dividend? (I’m still looking for the answer to that one)
Ok, so I don’t get taxed right away on this Return of Capital. When do I get taxed? Well, it turns out that when you get this Return of Capital, it reduces your cost basis in the holding. (In other words, if you lay down $100 dollars for the stock, then get a $20 ROC (reducing your basis to $80). When you go to sell the stock, you will no pay capital gains with $80 as your basis instead of $100 (and hence a larger capital gain). In theory, you win since the capital gain will be taxed at less than the original dividend.
The last question that entered my mind was “What happens when my basis hits zero?” As near as I can tell, when your Return of Capital exceeds your investment, then the ROC is taxed immediately as a capital gain (presumably short term). The theory being that any distribution greater than the tax basis is considered a gain from a sale of stock.