Return OF capital vs Return ON capital? (Syndication LP Investor)

[Chris Collins]

As a passive investor in an apartment syndication, you receive distributions along the way, then a larger chunk if/when the property sells or is refinanced.

These payouts to the investor are typically deemed either "Return OF capital" or "Return ON capital"

QUESTION: What is the difference and how does it affect the investor? 

-How does it affect the initial invested dollar amount?

-How does it affect the money you have left in the deal?

-How does it affect your % ownership in the deal?

-Is there a TAX implication based on this wording?

-As an investor, which do you prefer for you?

-As an operator, which do you prefer for your investors?

Thanks in advance!

-Chris

[Evan Polaski]

@Chris Collins, honestly it also depends on how the waterfall is structured, and how each individual views it.  I won't even say it is LP vs GP.  

If I invest 100k, and start getting back 7k per year, regardless of classification, that is, depending on your views, reducing my risk of total loss by 7k.  

-How does it affect the initial invested dollar amount? - I would say it doesn't effect your initial invested capital from a tactical standpoint, but from a return calculation standpoint, if it is classified as return OF capital, it is reducing your invested capital which means any future returns will likely be higher, even if marginally.

-How does it affect the money you have left in the deal? - Technically, return OF leaves less capital in the deal, but from a tactical view I don't think this matters at all.  Money goes in, and money comes back.  From the LP perspective, the more money I get back the better.

-How does it affect your % ownership in the deal? - Typically, return of capital is not reducing your ownership and return on is never reducing ownership.  I am sure there are structures that do this, but most syndications I have seen a return of capital is not altering ownership interest.

-Is there a TAX implication based on this wording? Yes.  Return of capital, in my experience, is non-taxable.  Return on capital is. But return of capital reduces basis, so upon sale, there is a lower basis in deal, and therefore more taxable gains.  The upside for many is if it is return ON, it is taxed at ordinary income this year.  If it is return OF, it is both deferred and then comes through as a long term capital gain, which is currently a lower tax rate than ordinary income.

-As an investor, which do you prefer for you? Return OF for tax purposes and return ON for capital account and return calculations.  Yes, this can be done.

-As an operator, which do you prefer for your investors? What is best for the investor.  Syndication is a long term play, if you are making decisions that are detrimental to your LPs, you will not be in business long.