For today’s episode, we’re going to be talking about an interesting, nuanced topic that came up recently in a chat with an investor. This going to be a conversation that is helpful for both active and passive investors.
We’re going to discuss the very subtle difference between the return OF capital versus return ON capital. The difference of one single letter in that string of words changes the entire dynamic.
We will talk about these things…and more in another episode of Multifamily Investing Made Simple in under 10 minutes.
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“If you’re contributing capital to a deal and we give you money back, give you your initial investment back, that’s the return of capital.” – Dan Kreuger
“Preferred returns are going to depend on your operator and how they structured the deal. You’re going to pay very close attention to whether or not the preferred return is OF or ON return because that can change just depending on how they word it” – Anthony Vicino
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Is It Return OF or ON Capital?
Anthony Vicino : [00:00:15] He. Everybody, how’s it going? This is Anthony Vecino with Invictus Capital. Welcome to multifamily investing made simple the podcast. It’s all about taking the complexity out of real estate investing so that you can take action today. Dan, I did something completely different. I’m scared with the intro. What have I done?
Dan Krueger: [00:00:36] I like to start singing the song from The Lion King.
Anthony Vicino : [00:00:39] That’s a good song. Did I have I ever told you? Lion King is my favorite movie
Dan Krueger: [00:00:43] Of all time. Have not told me that
Anthony Vicino : [00:00:44] It is now. Everybody knows it’s out. It is a good movie. I can’t take it back. And it’s true. It actually is legitimately my favorite.
Dan Krueger: [00:00:50] Do you ever see the state, the Broadway production? No.
Anthony Vicino : [00:00:53] Check it out. I should. I’m just not seeing that. I’m not fancy you don’t. I’m a cartoonist.
Dan Krueger: [00:00:59] I didn’t see it on Broadway. I saw it. I’m a cartoon
Anthony Vicino : [00:01:01] Guy in
Dan Krueger: [00:01:03] Milwaukee. I think Milwaukee.
Anthony Vicino : [00:01:05] I don’t want to go to Milwaukee to watch Lion King.
Dan Krueger: [00:01:06] They come here too. I just happened, Oh,
Anthony Vicino : [00:01:07] Okay, all right. Cool. Well, anyways, okay, so. Let’s see. Today, we’re going to be talking about an interesting, nuanced topic that came up recently in a chat with an investor is going to be a conversation. That’s helpful, I think for both active and passive investors, it’s the very subtle difference between the return of capital versus return on capital. The difference of one single letter in that string of words changes the entire dynamic. So Dan, let’s layout what is the return of capital versus return on capital? When do those come into play and why do we even care about it?
Dan Krueger: [00:01:47] Yes, I was doodling, and now I am paying attention
Anthony Vicino : [00:01:50] Can confirm he is doodling.
Dan Krueger: [00:01:52] It’s supposed to be a house. Don’t pay attention.
Anthony Vicino : [00:01:54] He just loves real estate so much.
Dan Krueger: [00:01:57] All right. Difference between the return of capital and return on capital. One of the biggest pieces about this that really matters to a passive investor is that if you give us money in an investment if you’re contributing capital to a deal and we give you money back, give you your money back, your initial investment back, that’s the return of capital. Mm-hmm. And you should not be getting taxed on that because we’re just giving you your original investment back. So that’s one of the biggest pieces there. Return of capital. Is not taxed return on capital. That’s again that’s a profit that would be a taxable thing, that’s probably the biggest nuance that that passive investor would care about on that there are some others, but I think that’s probably the big one.
Anthony Vicino : [00:02:44] Yeah. So let’s walk through throughout a, say, a real estate transaction or apartment syndication. Let’s take there’s a couple of times as an investor that you’re going to be getting money back. The first would be quarterly distributions. So every quarter, every month, hopefully, we have a cash-flowing positive asset that is kicking off some profit. Oh yeah. And every quarter that’s going to get redistributed back out to our investors. Dan, is that return of or return on capital? And this is tricky. It depends. This is a tricky one,
Dan Krueger: [00:03:12] Depends on if it’s below the preferred return hurdle or above it.
Anthony Vicino : [00:03:17] Yeah, OK. So this is where things just got a little bit more complicated. So what is the preferred return and we have episodes on this. So if you need to go and dive into that one, the preferred return is just saying up to this amount. The limited partners are entitled to getting that return before the GP gets any of their shares. So if we have a seven percent preferred return, then that means LPs have to achieve a minimum of seven percent return before the GP’s get any share of the profits. Ok. So if we return six percent, or let’s say, up to seven percent, so that preferred return is that return on or of capital. Of love. And then beyond that, is it return of or on? All right.
Dan Krueger: [00:04:05] So for our listeners, that means that the first seven percent is not going to be taxed like everything that comes after that, seven percent can be taxed differently. Yep.
Anthony Vicino : [00:04:16] All right. So let’s go to the cash-out refinance. That’s probably the next stage where you’re going to be getting some dollars back into your pocket. Is this return of or return on capital
Dan Krueger: [00:04:25] Of all
Anthony Vicino : [00:04:26] Daylong? Return of capital. So that means. Wait, wait, wait. So let me get this right. So if the cash-out refinance, we return say like 50 to 60 percent of your initial capital, that’s the return of capital, therefore tax-free. So I’m getting my money. I’m getting like 50 percent of my money back and I’m not getting taxed on it.
Dan Krueger: [00:04:43] That’s correct. Ok. And that’s part of what you still, at least in our deals. Not everyone does this, but in our deals, if you owned, let’s say, five percent of the equity in this deal and then we do that refi return of the capital non-taxable event, you get half it back. You still own five percent.
Anthony Vicino : [00:05:00] Still own five percent. Now here’s a trick question, not a trick question, but a tricky question after a cash-out refinance, let’s say I initially invested $100000 and we have a seven percent preferred return. So in the first couple of years, I’m getting about $7000 every year of preferred return. Now, in year three, let’s say we do a cash-out refinance and I get 50 percent of my capital back. So you just hand me back $50000. I’m like, Heck, yeah, that’s tax-free. I still have $50000 in the deal.
Dan Krueger: [00:05:26] Just I just hand you a wad of handed
Anthony Vicino : [00:05:28] Me a wad of cash. That’s how we know this is how we do our distribution wads of cash. Now I have $50000 still in the deal. What is my preferred return calculated on is that seven percent of my original investment of one hundred thousand or is it on this new amount to fifty thousand?
Dan Krueger: [00:05:43] That’s an excellent question. I’m glad you asked. It’s on the new it’s called your capital account. Ok, so if you invest in one of these deals and so you invest $100000 as Anthony said, that’s your capital account. And as we go through the period, go through the process of this deal. Month by month, quarter by quarter, you know, there’s cash flow coming. There’s the cash-out refi. That capital account will start to be reduced in line with the return of capital. We just chatted about it. And so the preferred return is going to be based on that capital account. It’s not permanently pegged to your initial investment, it’s pegged to the balance of that capital account. So when that refinance takes place, that is the return of capital and that capital account is reduced. That means going forward, your preferred return is going to be based on that capital account. And so that’s a lower hurdle for the preferred return, which is fine. You’re still going to get the same pro-rata share of profits. It’s just that that that that hurdle is a little bit lower now.
Anthony Vicino : [00:06:49] So let’s add another layer here because we talked about how the preferred return and this guy and gals are going to depend on your operator and how they structured the deal. And you’re going to pay very close attention to whether or not the preferred return is a return of verses because that can change just depending on how they word it should be the return of capital. So in that case, in the first couple of years, my preferred return that’s actually reducing my capital account. Ok, so if I get a $7000, seven percent return on my $100000 investment and that’s a preferred return in a year to my capital account at ninety-three thousand, and that’s now what the seven percent is going to be generated off of. All right. I’m trying to get the picture here, which is good because I’ve been doing this for a long time. It’s about time these things start to make sense to me. Now, last, probably the last time that you’re going to get money back in a deal is when we sell it and we dispose of the asset, we throw it in the garbage. We said, we’re done with this and somebody hands us a bag of cash. Is that return of capital or return on capital?
Dan Krueger: [00:07:51] Ok, so the sales proceeds are almost always going to be a return on capital. Now there’s it’s kind of depends on the deal. If you still have a rather hefty capital account, you’re always going to have to deplete that first, right until that capital account is depleted. We’re not really going to be able to say that, OK, this is one hundred percent return on capital. So but in almost all situations, I would imagine that that that sales transaction in that final year is all return on capital,
Anthony Vicino : [00:08:20] But that it depends is a portion of that to wipe out any past capital account, then. So like if you have like fifteen thousand left in the capital account, the first fifteen thousand of the proceeds goes as the return of capital and then the remainder is the return on capital.
Dan Krueger: [00:08:35] Yeah, I mean, if you think about it like this, if you got into a deal where there was no return of or on capital at all and there’s just no cash going back until the very final day when it’s sold, the first thing that happens is that capital account will go down to zero and that return of capital will be non-taxable and then everything else will be taxed. So I would assume that by year five, six seven, whatever is not much left in there. Much love, especially if there is a refi. But it could be a development deal. Yeah, you know, it’s not impossible for that to happen, but on our deals, it’s almost always going to be the vast majority of that final year is going to be returned on capital. Yep.
Anthony Vicino : [00:09:13] All right. So that is the return of versus return on capital. And under 10 minutes, we actually went more into the weeds on this one than we typically do. But there is a lot of nuances to it, and it’s an important one because how you get taxed really matters. You know, it’s not about what you make is about what you keep. And we want to understand, what do you actually get to keep in these investments? And when don’t you get to keep it so we can prepare accordingly? So you get more questions, feel free to reach out to us because this can be a complicated topic and we will keep trying to explain it with pictures of houses as much as possible until you get it. It took me, it took me until just now to understand it.
Dan Krueger: [00:09:47] So, so and I will say that this is a perfect topic for a CPA as well. We can walk you through how our deals are structured and how this theoretically should play out. But to really get. You know, the best possible answer to any kind of tax question to your situation is going to be able to tell you that and they can, you know, you can show them the documents from a deal you’re investing in with anybody and they can walk you through exactly how that should be playing out from a tax perspective. But we’ll help you.
Anthony Vicino : [00:10:19] No great disclaimer. So we’re not your CPA. We just play one on TV. Nope. All right. So that’s going to do it for us, lovely ladies and lads. Yeah, I said that right? Lovely ladies and lads. We will see you in the next episode. But before we get there, make sure that you just maybe go share this episode with somebody that you think would get some value out of it. If you have just started diving into the wild, wacky world of real estate investing. And it’s new and exciting for you, and you got somebody at work or a friend or a brother that you think would benefit from this. Shove it in their face and make them listen to it at all costs. Be aggressive with it because we’re talking about their financial future. Ok, and maybe don’t be. So that’s a lot. Maybe just be kind of coy about it. Like, Hey, I got this new thing. You might be interested.
Dan Krueger: [00:11:04] Send him a text with a link to him. And that’s how it works.
Anthony Vicino : [00:11:06] Different strokes for different folks. Whatever you do, make sure that you share this with a friend or family member, somebody that you think would get some value out of it, and we will see you next. Boom.