Return ON capital VS. Return OF capital in syndications

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Return ON capital VS. Return OF capital in syndications

Kyle Kovats
Rental Property Investor · Hoboken, NJ · Member since 2014 · 65 posts · 64 votes

How are your syndications OA's structured, return OF or return ON capital? 

Here is an example, 



7.3. Distributions of Net Cash Flow. The Company shall distribute Net Cash Flow as follows:
(a) First, an amount, if any, to the Members for any Additional Capital that they may have contributed.
(b) Next, in the Managers’ sole discretion, to the Class A and Class B Members in an amount representing the return of all Capital Contributions of the Class A and Class B Members. 11
(c) Lastly, to the extent remaining, eighty percent (84%) to the Class A Members, to be distributed to the Class A Members in accordance with their respective Percentage Interest in Class A, and twenty percent (16%) to the Class B Members, in accordance with their respective Percentage Interest in Class B.


Are there any tax advantages to structuring this as a "return of capital" as opposed to a "return on capital" during the hold period? This way you're only hit with a taxable event at time of sale from the large capital event since the distributions during the hold are just technically a return OF your capital. However, this would not work out so well if the market were to drop on the back end. Would love to hear some opinions on this one

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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
7y

Distributions and income are not the same thing—so you can call the distributions anything you want and it won’t change the amount of tax the investors will pay, nor when those taxes will be due.

In most cases my operating agreements are worded to distribute the preferred return first, followed by other return ON capital.  Return OF capital is either only capital events (such as cash-out refinance or sale), or next after the pref but before other Waterfall tiers.

The reason I don’t usually do return OF capital first is because each distribution would reduce the investor’s capital balance, which in turn reduces the preferred return due for the next period. This is favorable to the sponsor but not to the investor.  We sponsors have enough advantages, so whenever I can make a simple decision that favors the investor, I will.

If your waterfall is calculated on IRR split tiers instead of an annual return, the order is moot because "return of" and "return on" are treated the same, without any distinction, simply by definition.

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  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    7y

    Distributions and income are not the same thing—so you can call the distributions anything you want and it won’t change the amount of tax the investors will pay, nor when those taxes will be due.

    In most cases my operating agreements are worded to distribute the preferred return first, followed by other return ON capital.  Return OF capital is either only capital events (such as cash-out refinance or sale), or next after the pref but before other Waterfall tiers.

    The reason I don’t usually do return OF capital first is because each distribution would reduce the investor’s capital balance, which in turn reduces the preferred return due for the next period. This is favorable to the sponsor but not to the investor.  We sponsors have enough advantages, so whenever I can make a simple decision that favors the investor, I will.

    If your waterfall is calculated on IRR split tiers instead of an annual return, the order is moot because "return of" and "return on" are treated the same, without any distinction, simply by definition.

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  • Matt BontragerBusiness Member
    CPA · Henderson, NV · Member since 2016 · 75 posts · 13 votes
    5y

    @Brian Burke a return ON Capital would then be a deduction to the partnership and interest income to the partners correct?

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  • Evan Polaski
    Cincinnati, OH · Member since 2020 · 4k+ posts · 3k+ votes
    5y

    @Matt Bontrager, not necessarily, but possibly.  Each sponsor can treat this in a few different ways.  The most common way I have seen (and only way, frankly, in my LP investments) is: from a tax perspective every dollar sent to investors is considered a distribution, and thereby reduces taxable basis and defers taxes owed on those distributions.

    Internally, the sponsors classify every dollar paid up to the pref rate as a return ON capital, so as not to reduce the capital balance and pref owed.  Distributions in excess of the pref are return OF capital, until the initial investment has been fully returned, then back to return ON capital.  

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  • Todd Dexheimer
    Rental Property Investor · St. Paul, MN · Member since 2016 · 3k+ posts · 3k+ votes
    5y

    No tax advantages with way. We do return on capital. Return of capital is a disadvantage to the investor due to reducing their principal balance, in turn reducing the amount they are owed in preferred return and making it far easier to hit waterfall hurdles.  

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  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    5y
    Originally posted by @Matt Bontrager:

    @Brian Burke a return ON Capital would then be a deduction to the partnership and interest income to the partners correct?

    Return ON capital wouldn't be a deduction to the partnership, assuming the partnership is a pass-through entity it's just an income distribution to the partners.  It wouldn't be interest income to the partners unless it was interest income to the partnership, or unless the partnership was structured as a debt instrument rather than equity.  In an equity investment scenario, return ON capital distributions might be income from rental property, business income, or capital gain.

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