Return OF capital vs Return ON capital? (Syndication LP Investor)
Multifamily Investor · Newport Beach, CA · Member since 2015 · 176 posts · 182 votes
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
@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.
This is a topic much discussed in the MF syndication community.
It’s a complex issue. And one which may be difficult to discuss on a Forum like BP.
Folks tend to have strong opinions both ways - return on or return of.
If you are selling “cash flow” assets - assets that produce income - and asking investors to invest in “cash flow” assets - logically it seems to me the distributions should be considered return ON capital. The cash flow is the return ON your investment. The cash flow results from the net operating income produced by the investment. To consider it return OF is akin to just giving the LP their money back.
This maintains the LP share of the investment and maintains the original LP capital account upon which the preferred return is based. If distributions are considered return OF capital, then LP capital account is reduced and pref payments reduced accordingly.
I repeat this is a very complex issue and all the details of the deal matter.
In general, I would say return ON is a better arrangement for the LPs and logically there worse for GPs. Those operators that handle as distributions as return OF capital argue it reduces LP tax liability - given the amount of depreciation these deals generate - most of the income is sheltered anyway. So I find that argument less than compelling.
Now there may be instances with individual LPs and their unique tax and income situations where treating distributions as return OF might be beneficial.
But in general, treating distributions as return ON capital is the most logical way to do it. You invest in a “cash flow” asset to get a return ON your investment. You invest in a “cash flow” asset so it produces income for you. In this scenario, you can your capital back (return OF) upon sale or refinance.
Let me put it this way……
If an investor buys a single family rental house that produces income, does the investor consider that cash flow as a return OF capital or a return ON capital? The answer is clear. It’s return ON.
I will be interested to see how other chime in.
@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.
@Evan Polaski what a great write-up. That made things much clearer for me as far as the tax implication.
I agree, 'money is money' and whatever you classify it, its still the same $ in my pocket assuming you maintain the % ownership.
So the tax benefit of 'long term capital gains' vs 'ordinary income' during the hold makes a ton of sense to me.
Can you elaborate on this statment??
-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.
@Arn Cenedella I agree with your point too, that return 'on' capital makes the most sense in the traditional 'how you think of it.' I don't want to invest money, and then they just give me the money back and call it a 'return.' Cuz i could have just kept my money in the first place.
But I think the longer term tax implications especially when you go to sell, makes sense certainly to have it all be return 'of' capital, so you have lower basis at sale, and those proceeds are taxed lower than getting them each year as ordinary income?
We structure our waterfalls so that first investors receive a preferred return of 8% on their money. Then, anything distributed over that is a return of capital. Our preferred return is cumulative and compounding. So, if you invest 100k, your pref in year 1 is $8,000. If we didn't pay out any pref in year 1, your capital account is now $108k in year 2, so we now have to pay out $8,640 (8% on 108k) to meet pref in year 2. This structure is much more beneficial to the investor.
In general, and most simplistically the scenario is as follows:
1. In a fair model and as an LP you get a return ON capitol for any pref or excess cash flow from the deal (It is not desirable for this to be a return of capitol as that would decrease your capitol account) and this is taxable (however usually offset by depreciation).
2. Secondarily, you get a return OF capital at the time of an Refi/ or Sale and this is not taxable.
I don't invest in deals as an LP just to get my money back even if that is a non-taxable event. I invest to make money in these deals. Need to read PPM and look at distributions section as there are some syndicators out there who may be less than transparent about this. Need to educate yourself on deal vetting as an LP, and there are many good places and books to learn this.
Happy to share my 2cts as a pure LP investor (have never operated/syndicated/GPed a deal)...
When I receive distributions from a deal, either ON or OF the capital I originally invested, I decrease my risk exposure to the deal (as @Evan Polaski mentioned).
So if my initial investment was $100k and I received an accumulated amount of $40k back over time, my exposure at that point in time is $60k. Doesn't matter to me if the $40k was ON or OF capital, it's still money in the bank in my mind.
Yes, there are different tax implications to each type of distribution, but that's a different discussion.
Now the real question here is - What happens to future distributions if you've received return OF capital.
I'll explain what I mean here:
Let's say there is an 8% annual pref or CoC return on the investment example above.
This means that originally I should receive $8k per year (8% on $100k, distributed every quarter).
Now that I have received $40k return OF capital, do I get 8% on the remaining $60k? Or even more extreme - What happens if after a year I received my original $100k back as return OF capital. Do I get any type of annual distribution going forward?
I've seen so many different approaches to this it's crazy.
As an LP, I think the fairest model should be for the GP to distribute the annual profit, after keeping some money in the bank for worst case scenarios, and distribute the rest pro-rata with the LPs (or based an agreed upon waterfall).
Just my 2cts, I'm sure the others might be able to shed some light on this.
@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.
@Evan Polaski - When you say " 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."
Is that "return on" portion ordinary income every year or just the first year?
Income is taxed every year not just year one.
Depreciation usually shelters most if not all income tax due on distributions anyway.
The bigger tax issue occurs upon sale.
Your comment is spot on.
Reducing the LP capital account (with return OF) may impact subsequent distributions.
LP investor need to ask their GP how this will be handled.
It’s a similar question to what happens with a refinance and return of capital, is the LP share diluted.
As you note, I’ve seen deals where it is not and deals where it is.
LPs need to find out.
Income is taxed every year not just year one.
Depreciation usually shelters most if not all income tax due on distributions anyway.
The bigger tax issue occurs upon sale.
Thanks for the quick response.
I was really wondering about the Ordinary vs. Capital gains treatment of the income after year one.
Depreciation vs. Depreciation recapture is just a timing issue in my opinion. Nice to get it during the hold period, but stings on the sale due to the lowered basis. I think the depreciation benefit of real estate is often oversold as if it is this magical free expense you get to deduct for tax purposes without considering every year the depreciation benefit you take reduces your basis and is "recaptured" upon sale, oftentimes at a higher tax rate when considering that hopefully income increases over time, thus bumping up tax brackets. Anyhow, not intending to hijack the thread with a depreciation conversation.
Disclaimer, all taxes issues should be discussed with your CPA! 😀
In a similar vein to your comment, it’s a tax-deferred 1031 exchange not a tax-free 1031 exchange.
No free lunch from IRS.
Depreciation is more a tax deferral than tax savings.
That being said, often depreciation is taxed at capital gains rate (now maxed at 20%?) where many high income folks have ordinary income tax rates of 30% to 35% add in state taxes and it goes to 50% in some cases.
The depreciation benefit is real but yes sometimes oversold.
The tax system is complicated. Strategies that work for one investor may not work for others.
Investors often focus on tax issues before investment issues, that is a mistake.
Focus on investment aspects first. Is this a good investment? If yes, consider tax issues. If not, walk away.
@Jake Wiley, my counterpoint to depreciation being oversold is what can you do with that savings. Again if shielding income that would otherwise be taxed at ordinary income, you get an effective savings of 10% (35% to 25% rate). Of course, for the "normal" accredited investor, this isn't a huge savings, but still a savings. For your $5mm investor, this becomes very sizable and real money. Then you also have the opportunity cost of capital, and if you can achieve net returns in the mid-teens in a deal, you start compounding that deferral value.
But generally, I agree with you Jake. It is oversold and I hear from other investors who talk about sponsors implying these are tax-free investments, which as Arn and you both state, they are not. Well, under current tax code, unless you die. Then they can be tax-free with all the deferrals and step up basis upon death. Typically, I wouldn't recommend this route just to avoid paying taxes.
@Chris Collins. Great post and responses here! As an LP and a GP investor, I can see pros and cons to both. You might want to Google this and check it out: differences between European waterfall structure and American waterfall structure. This is another way of talking about this topic.
The European waterfall typically returns all capital to investors first. This lowers the principal balance and this typically lowers the preferred return hurtle calculation. There is no tax on return of principle which is a benefit. The significantly delays the syndicator’s timing on getting paid.
The American waterfall typically pays returns on investment first which are theoretically taxable as income (except depreciation helps). Return of capital happens above the preferred return, in a refinance, or asset sale. The syndicator could get into the profit share earlier but the preferred return hurdle stays higher for longer, keeping the LP investor at a higher preferred return for longer.
I’ve never done the calculations, but it seems to me that it will work out the same in the end for both parties, however the timing is obviously very different. Happy Investing!