Now that you understand the risks investors face, the next question is: what do investors earn for taking those risks? The Series 7 tests your ability to distinguish between different types of returns and their tax treatment.
Return of Capital (Return of Principal)
- A distribution that is not from earnings or profits; it is a return of the investor's own investment
- Return of capital is not taxable when received
- Instead, it reduces the investor's cost basis in the security
- If cost basis is reduced to zero, any additional return of capital is taxed as a capital gain
- Common with: REITs, MLPs, some mutual funds (particularly those with distributions exceeding net income), and limited partnerships (DPPs)
- Disclosed on Form 1099-DIV in box 3 (nondividend distributions)
How cost basis reduction works:
| Step | Event | Cost Basis |
|---|---|---|
| 1 | Buy 100 shares at $50 | $5,000 |
| 2 | Receive $500 return of capital | $4,500 (reduced by $500) |
| 3 | Receive another $500 return of capital | $4,000 |
| ... | Continue receiving distributions | Keeps declining |
| N | Cost basis reaches $0 | $0 - any further return of capital is taxed as capital gain |
Exam Tip: Gotchas
- Return of capital is NOT income. It is the investor's own money coming back. When a distribution exceeds a fund's earnings and profits, the excess portion is return of capital, reducing cost basis.
- Once cost basis hits zero, return of capital becomes a capital gain. This catches students who assume return of capital is always tax-free.
Tax-Exempt Interest
- Interest income that is excluded from federal income tax (and often state/local tax for in-state residents)
- Municipal bond interest is the primary source of tax-exempt interest
Key points:
- General obligation (GO) bonds and revenue bonds both pay tax-exempt interest at the federal level
- In-state advantage: interest from municipal bonds issued in the investor's home state is typically exempt from state and local taxes as well ("triple tax-exempt")
- Private activity bonds (certain municipal bonds financing non-governmental projects): interest may be a preference item for the alternative minimum tax (AMT)
- Tax-exempt interest is reported on tax returns (Form 1040) but is not included in taxable income
- Tax-exempt income is most beneficial for investors in high tax brackets
Tax-Equivalent Yield
This formula converts a tax-exempt yield to the equivalent taxable yield for comparison:
Tax-Equivalent Yield = Tax-Exempt Yield / (1 - Marginal Tax Rate)
| Municipal Yield | Tax Bracket | Calculation | Tax-Equivalent Yield |
|---|---|---|---|
| 4.00% | 32% | 4.00% / (1 - 0.32) = 4.00% / 0.68 | 5.88% |
| 3.50% | 35% | 3.50% / (1 - 0.35) = 3.50% / 0.65 | 5.38% |
| 3.00% | 24% | 3.00% / (1 - 0.24) = 3.00% / 0.76 | 3.95% |
Key point: The higher the tax bracket, the more attractive tax-exempt bonds become.
Exam Tip: Gotchas
- Tax-equivalent yield is a key calculation. Divide the municipal yield by (1 - tax rate), then compare the result to the taxable bond yield to determine which is more advantageous.
- Private activity bond interest may trigger AMT. Not all municipal bond interest is completely tax-free.
Taxable Interest and Dividend Income
Different types of investment income receive different tax treatment:
Interest Income
| Source | Federal Tax | State/Local Tax |
|---|---|---|
| Corporate bonds | Ordinary income | Yes |
| U.S. Treasury securities | Ordinary income | Exempt from state and local |
| Municipal bonds | Exempt (generally) | Exempt if in-state ("triple tax-exempt") |
Dividend Income
| Type | Tax Treatment | Requirements |
|---|---|---|
| Qualified dividends | Preferential long-term capital gains rates (0%, 15%, or 20%) | Must hold stock more than 60 days during the 121-day period around the ex-dividend date; must be paid by a U.S. corporation or qualified foreign corporation |
| Nonqualified (ordinary) dividends | Ordinary income rates | Does not meet holding period or issuer requirements |
Capital Gains
- Short-term (held 1 year or less): Taxed as ordinary income
- Long-term (held more than 1 year): Preferential rates (0%, 15%, or 20% depending on income)
Exam Tip: Gotchas
- Treasury interest is exempt from state/local tax, but NOT from federal tax. This is the opposite pattern from municipal bonds.
- Qualified dividends require a 60-day holding period during the 121-day window around the ex-dividend date to receive preferential capital gains rates. Miss the holding period and you pay ordinary income rates.
- Short-term capital gains (held 1 year or less) are taxed as ordinary income. The "or less" is key: selling on the one-year anniversary still counts as short-term.
Total Return
- The complete measure of investment performance: income (interest, dividends) plus capital appreciation (or minus depreciation)
- Formula: (Income + Realized/Unrealized Gain or Loss) / Initial Investment
- Total return is the most comprehensive performance measure and is used for benchmark comparison
- Annualized return expresses total return on a per-year basis for comparing investments held over different time periods
Example:
- Buy a bond at $950, receive $60 in coupon payments, sell at $980
- Total return = ($60 + $30) / $950 = $90 / $950 = 9.47%
Exam Tip: Gotchas
- Total return includes BOTH income and capital gains/losses. A question asking for "total return" expects you to add coupon payments (or dividends) to any price change, then divide by the original investment.
- Unrealized gains count in total return. You do not need to sell the security for gains to be included in total return calculations.