Components of Return
Every investment return boils down to two things: income you receive while holding the investment, and changes in its value. Understanding these components is the foundation for everything else in this unit.
The Four Components
Investment return is the total gain or loss on an investment, made up of income and capital changes.
| Component | Definition | Example |
|---|---|---|
| Interest | Periodic income paid on debt securities | A bond pays a 5% coupon semiannually |
| Dividends | Distribution of corporate profits to shareholders | A stock pays $2.00/share quarterly |
| Realized gains/losses | Profit or loss when a security is sold | Buy at $50, sell at $70 = $20 realized gain |
| Unrealized gains/losses | Profit or loss on a security still held (paper gain/loss) | Buy at $50, currently worth $70 = $20 unrealized gain |
- Interest and dividends represent income: money the investment pays you
- Realized and unrealized gains represent capital changes: changes in the investment's market value
- The key distinction between realized and unrealized is whether you've actually sold: realized means the transaction is complete, unrealized means you're still holding
Exam Tip: Gotchas
- Unrealized gains are sometimes called "paper gains" because they only exist on paper. They become realized gains only when you sell. If the exam describes a scenario where a stock has risen in value, check whether the investor has sold. If not, the gain is unrealized.
Return of Capital
Not every distribution is income. Return of capital (also called return of principal) is a distribution that does NOT come from the company's earnings or profits. Instead, it's the company giving you back part of your original investment.
- Not taxable when received
- Reduces the investor's cost basis rather than being reported as income
- Common with REITs, master limited partnerships (MLPs), and some mutual funds
- Once the cost basis is reduced to zero, any additional return of capital becomes taxable as a capital gain
Think of it this way: Imagine you lend a friend $100, and they hand you back $10. You haven't earned anything; you just got part of your own money back. That is what return of capital does. Your "investment" is now effectively $90, not $100, because you already received $10 of it back.
How it works:
- You invest $10,000 in an MLP
- The MLP distributes $1,000 as return of capital
- You owe no tax on the $1,000 distribution
- Your cost basis drops from $10,000 to $9,000
- If you later sell for $10,000, your capital gain is $1,000 (not $0)
Exam Tip: Gotchas
- Return of capital is NOT income. It reduces the investor's cost basis. If the exam describes a distribution that exceeds a company's earnings and profits, the excess is a return of capital.
- Once the basis reaches zero, further return of capital distributions become taxable as capital gains.