This return of principal payments is often referred to as either “return of capital” or “non-dividend distributions.” As a return of your original investment (cost), they reduce your basis.

In order to figure your gain or loss using an average basis:

To calculate average basis:

You may no longer use the double-category method for figuring your average basis.  If you were using that method for shares you acquired before April 1, 2011 and you sell, exchange or otherwise dispose of those shares on or after April 1, 2011, you must figure the average basis of those shares by averaging together all identical shares in the account on April 1, 2011, regardless of holding period.

No, you may use a different method for shares in a different mutual fund.

If you have a split of shares in a mutual fund account, the basis calculation is treated in the same manner as a stock split.

A mutual fund is a regulated investment company that pools funds of investors allowing them to take advantage of a diversity of investments and professional asset management.

You own shares in the fund, but the fund owns assets such as shares of stock, corporate bonds, government obligations, etc. One of the ways the fund makes money for you is to sell these assets at a gain.

If the asset was held by the mutual fund for more than one year, the nature of the income is capital gain, which gets passed on to you. These are called capital gain distributions, which are distinguished on Form 1099-DIV (PDF) from other types of income such as ordinary dividends.

Capital gains distributions are taxed as long term capital gains regardless of how long you have owned the shares in the mutual fund.

Report the amounts shown in Form 1099-DIV, box 2a, on Schedule D (Form 1040) (PDF), line 13.  Review the Instructions for Form 1040 and the Instructions for Form 1040A for additional information.