What Is Return Of Capital vs Return On Capital?

When diving into the world of investments, it’s important to understand various financial concepts.  And two of those concepts I’ve encountered after investing in real estate syndications are Return of Capital and Return on Capital.

While these terms might sound similar, they have different meanings and implications.

As a passive investor, it’s important to understand these two concepts regarding returns, as it’ll help you optimize your investment strategy.

In this article, we’ll break down Return on Capital and Return of Capital, discuss the importance of each, highlight the key differences, and discuss how they impact your return as an investor.

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What Is Return Of Capital?

Return of capital (ROC) refers to the return of some or all of an investor’s initial investment. This should not be confused with return on capital, which is the return earned on the invested capital and is taxable.

The main purpose of the return of capital concept is to differentiate between the initial amount invested and the returns generated by that investment.

Unlike Return on Capital, Return of Capital happens when an investor receives their original investment back – whether partly or in full. This isn’t considered income or capital gains from the investment, but it reduces your initial investment balance.

Here’s an example:

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

Essentially, Return of Capital refers to the payments that an investor receives which returns a portion of the capital that he or she invested back to him or her. In real estate, it usually takes a number of years until the investor has all of the capital that he or she invested returned to him or her.

The source of Return of Capital is usually completed upon refinancing or sale, and not from the property’s income.

Effects On Share Price And Taxes

Return of capital (ROC) has two primary effects on an investor’s share price and taxes.

First, since ROC is a return of the original investment, it often reduces the asset’s cost basis. This means investors should adjust their cost basis downwards to account for the received ROC.

Second, ROC is generally not considered taxable income in the year it’s received. However, it reduces the cost basis, which may increase the investor’s capital gains tax liability when the asset is eventually sold.

Capital Gains Tax And Tax Rate

Capital gains tax applies to the profit made from the sale of an investment and varies depending on the holding period and tax bracket of the investor.

Generally, short-term capital gains (from assets held for one year or less) are taxed at the investor’s ordinary income tax rate.

Long-term capital gains (from assets held for more than one year) often benefit from lower tax rates, depending on the investor’s taxable income.

Related article: 5 Ways To Defer Capital Gains Tax When Selling Real Estate

Return Of Capital Benefits

Return of Capital (ROC) enables investors to reinvest in their portfolios and gain benefits without raising their taxable income.

By selecting investments that provide ROC distributions, investors can:

• Postpone tax obligations to a potentially more favorable future date.
• Accumulate interest on funds that would have been spent on taxes.
• Secure a consistent monthly income.
• Gain passive earnings from long-term investments.

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What Is Return On Capital?

Sticking with the real estate syndication example, the Return on Capital is a ratio that measures how a general partner or syndicator turns investors’ equity into profits.

When investors receive distributions from the property’s cash flow, this is considered a Return on Capital.

In other words, the Return on Capital is the amount of money that you receive each year as a result of making your initial investment.

Example:

• initial investment $100,000
• annual rental return $8,000
• Return on Capital 8%

Comparing Return Of Capital And Return On Capital

Key Differences

Aspect	Return of Capital	Return on Capital
Focus	Initial investment value returned to the investor.	Efficiency in generating profits from capital.
Past Performance	Centers on the value of the initial investment.	Evaluates company’s profit-generating performance.
Cash Flow	Cash flow paid back to the investor.	Cash flow generated by the investment.
Long-term Capital Gains	May affect long-term gains by reducing cost basis.	Generally not directly related to long-term gains.

Investors Distributions

As mentioned, in real estate syndications, distributions to investors are the profits generated from operations or property sale, typically distributed on a pro-rata basis according to their investment share.

These distributions can include both return of capital (ROC), which represents the investors’ initial investment, and return on capital (ROC), which is the profit generated on top of the initial investment.

Evaluating the distribution structure and how returns are allocated between return on capital and return of capital helps investors gauge whether a syndication investment aligns with their financial goals and risk tolerance.

Here’s another example:

Option 1:

• Initial investment: $150,000
• Annual rental return: $10,500
• Return on Capital every year: 7%

Option 2:

• Initial investment: $150,000
• Capital returned in year 1: $10,500
• Investment balance at beginning of year 2: $139,500
• Distribution in year 2: 7% of $139,500 (not $150,000 as in Option 1) = $9,765
• Distribution in year 3: 7% of $129,735 ($139,500 – $9,765) = $9,081.45

When you calculate profits from a property using the Return of Capital method, especially when selling the property, it might look like you’re making more money than you are (artificially higher IRR ).

This happens because at the time of sale, the money you get is based on a smaller amount of money than what you initially put in (like the $150,000 in the examples).

The majority of real estate sponsors prefer to give out profits as Return on Capital. This means they base your profits on the amount you originally invested.

This method keeps the amount of money you receive each year the same. Even if the property is refinanced, these managers might still calculate your profit based on the original amount you put in (aka infinite returns).

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Tax Considerations And Filing

Form 1099-DIV

Taxpayers who receive dividend income or distributions from investments may expect to receive a Form 1099-DIV at the end of the year.

This form provides details about the types of income received, including any return of capital payment.

IRS Form

The Internal Revenue Service (IRS) has specific forms and procedures to facilitate proper tax filing for those who receive dividend income or return of capital payments.

By properly reporting income on the appropriate forms, taxpayers can avoid potential penalties or additional taxes.

Conclusion

In the world of investing, understanding the difference between return of capital (ROC) and return on capital (RoC) is essential for making informed decisions. Both concepts are related to the returns an investor can expect from an investment, but they represent different aspects of that return.

Return of capital refers to the portion of an investment that is returned to the investor without being taxed as income. This can include original investments, such as principal amounts, or other non-taxable distributions.

On the other hand, return on capital is a measure of how well an investment is performing. It takes into account the profit generated by the investment and is typically expressed as a percentage.

Investors must carefully consider both ROI and ROC when evaluating the performance and risk associated with a particular investment. It is important to keep in mind that a high return on capital does not necessarily guarantee a high return of capital and vice versa.

Frequently Asked Questions

Can you explain the difference between return of capital and return on capital, especially in the context of mutual funds and investment decisions?

Return on capital refers to the profit you earn on the capital employed in an investment, such as mutual funds or dividend payments from stocks. It’s a key measure of a company’s returns and is closely watched by financial advisors and investors like Warren Buffett for assessing the long-term profitability and efficiency of capital employed.

Return of capital, on the other hand, is not a profit but a portion of the investment income that is returned to investors from the capital they originally invested. This can occur for various reasons, including mutual fund distributions or dividend payments that exceed the company’s earnings in a calendar year. For tax purposes, return of capital is considered a return of your investment, not income, which can lower your tax bill but also reduces the balance sheet’s capital employed, impacting future investment income.

Both concepts are important for making informed investment decisions, understanding a company’s balance sheet, and evaluating the cost of care exercise in investment advice. While return on capital aims for a higher return by focusing on the company’s profitability and investment income, return of capital reduces the invested capital, potentially affecting long-term investment advice and the distribution rate of fund distributions. It’s always a good thing to consult with financial advisors to understand these important profitability ratios and their implications for your investment strategy.

What are the tax implications for return of capital?

Return of capital (ROC) is generally not considered a taxable event and is not taxed as income. It represents the return of an investor’s original investment amount.

However, it can impact the cost basis of an investment, reducing it by the amount of the return of capital. This may result in a larger capital gain or a smaller capital loss when the investment is ultimately sold.

How is return of capital recorded in accounting?

In accounting, return of capital can typically be recorded as a reduction of the original investment cost basis.

This means that when the capital is returned to the investor, the investment’s value in the books will decrease by the amount of the return of capital. This reduction in cost basis can affect future calculations related to capital gains tax liability or net income from the investment.

What is the formula for return of capital?

There is no specific formula for return of capital. It is simply the portion of an investment distribution that represents a return of the investor’s original investment amount rather than income or profit generated by the investment.

Can you provide an example of return of capital?

Suppose an investor initially invests $1,000 in a real estate investment trust (REIT). At the end of the year, the investor receives a $100 distribution from the REIT, which includes $80 as return on capital (profit generated by the REIT) and $20 as return of capital.

In this case, the return of capital is the $20 that represents the return of a portion of the investor’s original $1,000 investment.

How does return on capital differ from return of capital in taxation?

Return on capital represents the profit earned on an investment and is generally subject to taxation as capital gains or income, depending on the type of investment and how long the investor held it. Return of capital, on the other hand, is not considered taxable income as it represents a return of the investor’s original investment amount.