The return of principal is not taxable. It is considered a return of the “cost” on an investment and therefore not recognized as income. When you sell property on an installment sale, the buyer typically makes installment payments to you, and this usually contains both interest and principal. Only the interest portion of the payment is taxable. To determine the taxable portion of an installment sale you must file form 6252 with your federal tax return.
The return of principal is not a taxable item, because it's simply the return of your investment ... not a capital gain or loss.
Taxable Portion of Sale
When you sell a property, a portion of the proceeds is considered a return of principal – or capital basis -- and this portion is not taxable. For example, if you paid $50,000 for a property and you sell it for $75,000, your taxable portion of the sale is $25,000 -- $75,000 less $50,000. The only portion that is taxable is the amount of appreciation earned above the original cost.
Installment Sale Calculations
When you sell property on an installment sale you receive future payments that include both a return of principal and income. Federal form 6252 is used for Installment Sale Income. With this form you determine your Gross Profit Percentage, which you use in subsequent years to determine what portion of the installment payments are taxable. For example, if you paid $100,000 for a property and sell it for $200,000, your gross profit percentage is 50 percent -- $100,000 divided by $200,000.
This percent is then used on subsequent future payments you receive to determine the taxable portion. For example, if the following year you receive $20,000 in payments, $10,000 would be taxable, assuming a 50 percent gross profit percentage.
Taxation and Dividend Rules
When you receive dividends, usually a portion of this is considered a return of capital and is not taxable. When you receive your annual 1099 DIV, it should allocate the taxable and non-taxable portions of the dividend. The investment house keeps track of this and is responsible for allocating the taxable and non-taxable portion. You should verify these numbers with your accountant to ensure they are accurate. You should keep records to show what your initial investment in the stock was, to help ascertain what your cost, or principal basis, was in the stock .
Other Important Considerations
A return of principal is the same thing as a return of your cost basis. When you purchase property, you should keep records that document the cost of your investment, because you may need this information in the future when you decide to sell the property. For real estate, you should keep a copy of the purchase contract and also a copy of the final HUD-1 settlement statement, which shows all the details of the transaction. Your accountant will need these documents to allocate cost basis from your taxable gain.