Return of capital distribution
A return of capital distribution (IRS terminology refers to these distributions as "nondividend distributions") differ from ordinary dividends in that they are not made out of earnings, but are made out of capital. Mutual funds are one of the business entities which can make a return of capital distribution. When an investment is held in a taxable account, these distributions are, under most circumstances, non-taxable. The distribution reduces the tax basis of the fund. Thus, the distribution is taxed at capital gains tax rates when an investor sells fund shares. If the return of capital distributions are larger than the tax basis of shares, the distribution is taxed as a capital gain.
- Example: An investor holds a stock with a $10 basis. The investor receives a $2 return of capital dividend. The $2 dividend is not taxable income. The investor reduces the basis of the stock to $8 dollars. If the investor sells the stock for $10, the $2 profit will be reported as a taxable gain and will be taxed as either a short term or long term gain depending on how long the investor has held the stock.
When you receive a return of capital distribution it will be reported on line 3 of the 1099-DIV. According to Fairmark, take the following steps to adjust basis:
- If you're using the single-category averaging method to determine your basis. Find the amount in box 3 of Form 1099-DIV and subtract that amount from the total basis of your shares.
- If you're using any other method to determine your basis:
- Start with the amount in box 3 of Form 1099-DIV.
- Divide that figure by the number of shares to which it applies. This tells you the amount of the adjustment per share.
- Use this per-share basis adjustment to decrease the basis of each separate group of shares you hold. 
Vanguard funds making return of capital distributions
Vanguard has a number of funds which are prone to make return of capital distributions.
- Real Estate funds: The Vanguard REIT Index Fund and Vanguard Global ex-U.S. Real Estate Index Fund. In the case of equity REIT funds, the return of capital distribution mainly reflects the accounting value of real estate depreciation (operating earnings are in excess of earnings including depreciation). As most dividends distributed by equity REITS are non-qualified dividends, taxed at marginal rates, the return of capital dividend serves, for taxable account investors, to both defer taxation and to switch the taxation of the distribution from marginal rates to usually lower capital gains rates.
- Managed Payout Funds: The Vanguard Managed Payout Growth Focus Fund, Vanguard Managed Payout Growth and Distribution Fund, and Vanguard Managed Payout Distribution Focus Fund. As a part of these fund's managed distribution policies, monthly income distributions can come from dividends, realized capital gains, and return of capital.
- Inflation-Protected Securities Fund Mutual funds which hold TIPS are required to distribute as dividends both the coupon on the bond and the inflation adjustment. In one quarter, deflation was more than the bond yield, and thus the amount Vanguard Inflation-Protected Securities Fund needed to distribute for the year was less after the fourth quarter than after the third quarter. The fund made no distribution, and recharacterized part of the third-quarter dividend as a return of capital so that the dividends for the full year would be the correct amount.
- Nondividend Distributions, Fairmark