You’ve probably heard the term “return on capital” or “return of capital” before, which is occasionally used incorrectly. Understanding these concepts and their importance when it comes to returns will allow you to become a more astute investor, optimize your strategy, and become a more successful investor.
In this blog, we will include a breakdown of Return on Capital and Return of Capital. We will also talk about their differences and how they impact your return as an investor.
Return on Capital
Syndication professionals use Return on Capital to assess how well an investor’s equity is converted into profits. You get a return on your capital when you receive distributions (monthly or quarterly) from rental income and other income generated by the property (fees, cable contract, etc.). So, if you invested $100,000 and received a 6% return annually ($6,000), your Return on Capital is 6%. Simply put, Return on Capital refers to the amount of money you receive each year as a reward for your initial investment.
Return of Capital
Return of Capital is when investors receive their original investment back, whether partially or in full. In the case of a return of capital, it does not count as income or capital gain from the investment, however, it does reduce the initial investment balance. Using the $100,000 investment example, if you invested $100,000 and received $6,000 in Year 1, then your investment balance in Year 2 is $94,000 ($100,000-$6,000). An investor’s Return of Capital refers to the payment they receive when a portion of the capital they invested is returned. A real estate investor will usually have to wait for a number of years before getting all of the capital invested back. This type of return is usually completed during a refinance or a sale, rather than from the income from the property.
Know The Difference
Understanding the difference between Return on Capital and Return of Capital is vital since Return on Capital tells you what annual returns you can expect for your initial investment, while Return of Capital tells you the rate at which you can recover your investment. Investing in a particular property often requires a thorough understanding of these two figures. Knowing these figures makes it easier for investors to determine whether or not a property will make for a good investment.
1. Distributions to Investors
As investors receive their distributions, they need to know if they are receiving Return on Capital or Return of Capital. This is vital because if you receive distributions according to Return of Capital, your investment balance will shrink as time passes, resulting in lower returns each year.
2. Tax Differences
There is a significant difference between Return on Capital and Return of Capital when it comes to taxation. Losses or gains are not included in Return of Capital. This is like receiving money back, so it is not considered taxable. In other words, you can receive your full investment back from a Return of Capital standpoint, and do not have to pay taxes on it up to the full dollar amount you invested.
On the other hand, Return on Capital is taxed the same way as normal rental income for real estate investors. Although the Return of Capital is not taxable, it is only so until the original investment balance has been repaid.
So, what is the best option?
As a real estate investor who invests in syndication, you cannot choose between Return on Capital and Return of Capital, since that decision will be made by the syndicator. However, both strategies have pros and cons. For example, Return of Capital offers significant tax advantages, but most of your payouts will decrease in value every year.
If you have a Return on Capital, your distribution payments won’t decrease in most cases, but they will be heavily taxed. Your choice of method depends on whether you just want a quick return on your investment with a low amount of tax or if you want a steady cash flow that can endure for years.
If you prefer the latter, Return on Capital is right for you. But if you choose the former, Return of Capital is the way to go.
Conclusion
For real estate investors, knowing the difference between Return on Capital and Return of Capital is important. If you choose Return on Capital, you will typically generate higher payouts (assuming the investment does well of course) while potentially paying more taxes, whereas Return of Capital will give you a tax advantage since you won’t pay taxes when you use your original investment to earn a dividend. Having identified which strategies are best suited to your objectives, you must thoroughly vet your sponsor and only consider investments that align with your overall wealth-building objectives.
Prashant Kumar, CCIM
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