Assessing the Sustainability and Tax Implications of Return of Capital Distributions in Closed-End Funds

Return of capital (ROC) distributions in closed-end funds (CEFs) have become a focal point for income-focused investors, particularly as funds like the Western Asset Inflation-Linked Opportunities & Income Fund (WIW) increasingly rely on this strategy to maintain regular payouts. While ROC offers immediate tax advantages, its sustainability and long-term implications for investors remain contentious. This article examines the balance between ROC and net investment income (NII), the risks of “destructive return of capital,” and the evolving tax landscape in 2025.

The Growing Role of ROC in CEF Distributions

WIW’s 2025 distribution strategy exemplifies the trend. As of July 31, 2025, 58.89% of its $0.0625 per-share August distribution was ROC, with cumulative year-to-date distributions showing 51.68% of the $0.4940 per share attributed to ROC [1]. This pattern mirrors broader industry practices, as seen in the Virtus NFJ fund, where 81.9% of year-to-date 2025 distributions are ROC [2]. Such reliance on ROC raises critical questions: Is the fund generating sufficient NII and realized gains to sustain payouts, or is it eroding its net asset value (NAV)?

ROC distributions are not taxable in the year received but reduce an investor’s cost basis, potentially increasing future capital gains liability [3]. For example, if an investor sells shares after repeated ROC distributions, the adjusted cost basis could be significantly lower, leading to higher taxes on gains. This dynamic is particularly relevant for CEFs trading at a discount to NAV, where ROC may mask poor asset management or overreliance on distribution strategies [4].

Sustainability Risks: Destructive vs. Strategic ROC

The term “destructive return of capital” describes scenarios where ROC erodes a fund’s NAV without corresponding performance gains [5]. This is evident in funds like Virtus Convertible & Income Fund II (NCZ), where the May 2025 distribution was entirely ROC with no NII or gains contribution [2]. Such practices signal a misalignment between payout commitments and income generation, risking long-term value for shareholders.

In contrast, CEFs with strong NII and capital gains can use ROC strategically. For instance, during market downturns, ROC can stabilize payouts without depleting NAV [1]. However, this requires robust asset management and a clear alignment between distribution policies and income generation. Investors must scrutinize a fund’s financial health, including its ability to cover payouts through NII and gains, to distinguish between sustainable and destructive ROC strategies.

Tax Implications Under 2025 Policy Changes

The 2025 tax landscape introduces new variables. The One Big Beautiful Bill Act (OBBBA), signed in July 2025, extends the 20% qualified business income (QBI) deduction for pass-through entities and reinstates 100% bonus depreciation for domestic R&D expenditures [6]. These provisions could reduce ordinary taxable income for funds, converting it to capital gains and delaying income recognition until realization events. While this benefits investors in the short term, it also amplifies the tax deferral risks associated with ROC.

Additionally, the expiration of the Tax Cuts and Jobs Act (TCJA) in 2025 may raise capital gains tax rates, increasing the cost of future gains for investors who have reduced their cost basis through ROC [3]. High-income investors must also consider the 3.8% Net Investment Income Tax (NIIT), which applies to investment income for those with modified adjusted gross incomes (MAGI) exceeding $200,000 (single) or $250,000 (married filing jointly) [6].

Conclusion: Balancing Tax Benefits and Long-Term Risks

For income-focused investors, ROC distributions offer immediate tax advantages but require careful evaluation of a fund’s sustainability. While WIW and similar CEFs demonstrate the utility of ROC in maintaining regular payouts, the risk of NAV erosion and future tax liabilities cannot be ignored. Investors should prioritize funds with strong NII coverage and transparent asset management, while monitoring broader tax policy shifts that could alter the cost-benefit equation.

As the 2025 tax environment evolves, the interplay between ROC, distribution sustainability, and tax efficiency will remain a critical consideration for CEF investors.

Source:
[1] Western Asset Inflation-Linked Opportunities & Income Fund, [https://www.businesswire.com/news/home/20250829650942/en/Western-Asset-Inflation-Linked-Opportunities-Income-Fund-WIW-or-the-Fund-CUSIP-95766R104-Announces-Notification-of-Sources-of-Distributions]
[2] Assessing the Risks and Rewards of Return of Capital ..., [https://www.ainvest.com/news/assessing-risks-rewards-return-capital-distributions-closed-funds-2508/]
[3] Return of Capital (ROC): What It Is, How It Works, and ..., [https://www.investopedia.com/terms/r/returnofcapital.asp]
[4] Evaluating Distribution Sustainability in NCV and NCZ, [https://www.ainvest.com/news/fixed-income-convertible-securities-closed-funds-evaluating-distribution-sustainability-ncv-ncz-2508/]
[5] Return of Capital and CEFs: Part 3, [https://www.fidelity.com/learning-center/investment-products/closed-end-funds/return-of-capital-part-three]
[6] One, Big, Beautiful Bill: Tax Impact for Private Equity and Registered Funds, [https://www.cohenco.com/knowledge-center/insights/july-2025/one-big-beautiful-bill-up-close-tax-impact-for-private-equity-and-registered-funds]