Return on Capital vs Return of Capital

Amongst the wide variety of terms in use in the real estate world, “Return on Capital” and “Return of Capital” are two which can easily be confused and, in fact, in some cases are mistakenly used interchangeably.

Yet, they are not the same, and it’s important for all investors to understand these and other related concepts relating to investment returns in order to optimise their investment strategy.

To start, let’s first have a look at the meaning of Return of Capital and appreciate the differences with Return on Capital.

Return of Capital (“RofC”)

Return of Capital is when an investor has their original investment returned, whether partly or in full, over a period of time. It is not considered as income or a capital gain but does reduce the amount of the initial investment over time.

This concept is best demonstrated by an example:

• initial investment $100,000
• capital returned in year 1: $6,000
• investment balance at beginning of year 2: $94,000

In short, Return of Capital refers to the payments by which an investor receives a portion of the capital which they have invested until such time as all the capital has been returned. It is not the same as a Preferred Return. 

The total repayment of RofC is usually completed upon a refinancing or sale and not from the property’s income.

Some benefits of Return of Capital

ROC allows an investor to contribute to their investment and benefit from it without

increasing their taxable income.

By deciding upon investments which offer ROC distributions, investors can:

• defer their tax liabilities until a later, more opportune time;
• earn interest on such money instead of paying it in taxes;
• receive a reliable monthly cash flow;
• receive passive income from the long-term investment.

Return on Capital (“RonC”)

On the other hand, Return on Capital is a ratio which measures how a general partner or syndicator turns investors’ equity into profits.

When an investor receives distributions (either monthly or quarterly) from the cashflow of a property from rentals and other income (fees, other services etc), then this is considered a Return on Capital, not of Capital.

By way of example:

• initial investment $100,000
• annual rental return $6,000
• Return on Capital 6%

Why it is necessary to know the difference

In Real Estate Private Equity Investments, knowing the difference between Return on Capital and Return of Capital is essential. This is because RonC allows investors to know what annual returns can be expected from their investment, whereas RofC lets investors know the interest rate or rate of return at which their initial investment can be recouped.

Return on Capital will, providing the investment is performing well, usually generate higher payouts, yet potentially be subject to higher tax payments. On the other hand, a Return of Capital investment strategy will probably result in lower payouts but provide tax advantages as investors will not pay taxes when their initial investment is being repaid.

Distributions to Investors

At the outset of the investment, investors need to establish whether they will receive distributions based on Return on Capital or Return of Capital.

As mentioned, if distributions are based on Return of Capital, then investors will receive lower returns each year, as these are based on the diminishing amount of the investment.

Again, an example:

Option 1:

• initial investment $100,000
• annual rental return $6,000
• Return on Capital every year 6%

Option 2:

• initial investment $100,000
• capital returned in year 1 $6,000
• investment balance at beginning of year 2 $94,000
• distribution in year 2 6% of $94,000 (not $100,000 as in Option 1) = $ 5,640
• distribution in year 3 6% of $88,360 ($94,000-5,640) = $ 5,302

Using the Return of Capital method to calculate returns from a property’s income will typically generate an artificially higher IRR when the property is being sold at a certain point in the real estate cycle. This is because, at the time of sale, an investors pro-rata share of sales proceeds is calculated based on a much lower investment than the original figure ($100,000 in the examples above). 

When many syndicators make distributions they prefer to treat these as Return on Capital. This is so that investors are being paid their percentage based on their original investment.

When distributions are paid this way annually, the dollar value of the investor’s distributions remains consistent. Some syndicators also keep paying the projected return on the initial investment even after refinancing, thereby continuing to peg the 6% return to the original investment.

Key tax differences between Return on Capital and Return of Capital

The taxation basis of Return on Capital and Return of Capital is also very different.

Return of Capital is similar to getting your money back and does not include gains or losses: therefore is not considered taxable. Investors can obtain a full return of their investment in a Return of Capital situation and not pay taxes on the full amount of investment made. 

Return on Capital, on the other hand, is considered rental income and is taxed the same way that other normal rental income is taxed.

In what situations is Return of Capital taxable?

Return of Capital income is not taxable as the amount of the investment is the amount invested initially. However this is as long as the adjusted cost basis (“ACB”) of the investment is greater than zero.

Whilst RofC distributions reduce the ACB, the taxpayer must report the difference between the sale price and the ACB as a capital gain when selling the investment. In such a case, 50% of such gain is taxable.

Therefore, the investor has full control over when they want to sell and subsequently pay taxes.

Which is the better option for investors?

Having said the foregoing, for a passive real estate investor investing in a syndication, it’s not possible to choose between receiving distributions via the Return on Capital or Return of Capital method as the syndicator will make that decision just as they would with the mode of financing.

Of course, there are pros and cons to each strategy such as, for example, RofC offers significant tax advantages, although payouts will decrease in value each and every year.

For Return on Capital distribution payments will remain stable, but will be more heavily taxed. The choice for an investor, if it’s possible to make it, depends on whether they want to recoup the investment quickly and pay the lowest amount of tax possible, or create steady cash flow which can last indefinitely for many years. 

CPI Capital has been involved in a wide variety of REPE transactions and always focuses on achieving the optimum result for its passive investors. Clearly, there are pros and cons for both Return on Capital and Return of Capital strategies and it’s up to us to use our knowledge and experience to determine the best way to handle distributions.

The effective mitigation of tax liabilities can be a major boost to investment returns from REPE investment into the multi-family sector, and this is yet another aspect where a knowledgeable general partner can provide “added-value” to real estate investments.

Yours sincerely
August Biniaz
CSO, COO, Co-Founder CPI Capital