As a passive real estate investor, one of the factors that you consider when choosing your investment strategy is the return on investment (ROI). The terms “Return of capital” and “Return on capital” are two often confusing words that you will come across when evaluating your investment returns. The truth of the matter is that the two are distinct and should not be used interchangeably. In this article, we shall explain the difference between “Return of capital” and “Return on capital” and how each of them impacts your real estate investment.
What is a Return on Capital?
Return on Capital refers to a profitability ratio that is used to indicate the efficiency of a real estate investment project by gauging its ability to generate profit from the capital employed. For instance, in real estate syndication, Return on Capital ratio measures how a given syndicate project can turn an investor’s equity into profits. For instance, if your initial capital investment was $100,000 and by the end of the first year you receive an annual return of $10,000, your “Return on Capital” would be 10%.
When you receive your paid distributions either monthly or annually which are generated from either the investment project rental income or other sources of income, that’s what equates to Return on Capital. In short, Return on Capital is the amount of profit that you receive at the end of a financial year from the initial capital invested.
What is Return of Capital?
Return of Capital refers to the return of the principal investment back to the capital owner either in part or full. Return of capital is not considered as income or capital gains from the investment. However, Return of Capital has a direct implication as it reduces your initial investment balance.
For instance, if your initial investment was $200,000 and you receive $10,000 as return of capital at the end of the first financial year, your investment balance as you start the second year will reduce by the same amount to $190,000. When investing in real estate, an investor can wait for several years before they can recoup the return of capital equivalent to the original investment capital.
Tax implications between return on capital and return of capital
Return on capital has a different tax formula from the one used in return of capital. For the return of capital, gains and losses are not included when calculating tax. Therefore, an investor is entitled to get their initial capital back in totality without paying any taxes until the original capital is fully paid off. Return on capital is viewed as rental income and therefore, it attracts tax implications similar to normal rental income rates.
Why is it important to know the difference between the return on capital and the return of capital?
Understanding the difference between the return on capital and return of capital is very critical to any real estate investor as it helps in investment decision-making. It becomes easy as return on capital helps investors calculate the expected annual returns from their initial capital investment. On the other hand, the return of capital helps real estate investors understand the time it will take for their initial investment to be recouped.