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FNCE 333 Lecture 5

FNCE 333 Lecture 5. Tax Analysis of Real Estate Investing Professor C. F. Sirmans. Lecture 5 -- Overview. After-Tax Cash Flows Operation -- ATCF Sale -- ATER Analyzing Tax Effects Taxable Income from Operation Mechanics of Depreciation Taxable Income from Sale

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FNCE 333 Lecture 5

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  1. FNCE 333Lecture 5 Tax Analysis of Real Estate Investing Professor C. F. Sirmans

  2. Lecture 5 -- Overview • After-Tax Cash Flows Operation -- ATCF Sale -- ATER • Analyzing Tax Effects • Taxable Income from Operation • Mechanics of Depreciation • Taxable Income from Sale • Alternative Exit Strategies

  3. Readings • B & F, Chapter 11 • Readings 12, 12, 13

  4. Tax Effects from Operation Operating a real estate investment generates potential income tax effects. To calculate these tax effects the investor must understand the tax consequences of (i) operating expenses, (ii) debt financing, and (iii) the depreciation deduction.

  5. Tax Effects from Operation • Cash flows Versus • Taxable income

  6. After-Tax Cash Flow From Operation

  7. Taxable Income and Taxes From Operation

  8. Tax Calculation • To compute the amount of tax (any type, i.e., sales tax, property tax, income tax, capital gain tax), you need two inputs: A. The Amount to be Taxed B. The Tax Rate

  9. Tax Calculation • For investment decision making, the important tax rate is the marginal rate. • Marginal Rate versus Average Rate – Example

  10. Tax Rate • Suppose an investor has a Taxable Income of $100,000 and pays $20,000 in taxes. What is the (average) tax rate? Answer: 20% • Suppose the investor buys a real estate investment that produces $30,000 in additional taxable income, which results in a tax liability of $29,000 on the $130,000. What is the investor’s marginal tax rate? Answer: 30%

  11. Steps in Analyzing Tax Effects • Determine the tax classification • Form of business organization – corporate, individual, partnership, etc. • Type of real estate – income-producing residential, other commercial real estate, low-incoming residential, historic property • Determine investor’s marginal tax rate • Estimate taxable income – acquisition phase, operating phase, disposition phase • Compute expected taxes

  12. Four Classes of Real Propertyfor Tax Purposes • Real estate held as a personal residence • Real estate held for sale to others– dealer property • Real estate held for use in a trade or business– trade or business property • Real estate held as an investment for the production of income– investment property

  13. Types of Taxable Income • Active Income (e.g., salaries, wages, bonuses, and commissions.) • Portfolio Income (e.g., interest, dividends, and capital gains.) • Passive Income (e.g., rents from real estate, and royalties from oil and gas rights.)

  14. What happens if Taxable Income from Operation is Negative? • If taxable income is negative, the project is generating a “tax loss”, not a “cash flow” loss. • Determination of the deductibility of this tax loss depends on the passive/active income loss restrictions.

  15. Passive/Activity Loss Restrictions • Passive losses cannot be used to reduce active or portfolio income • Passive losses may be used to reduce other passive income • Passive losses not used may be used in future years or at the same time of sale • Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations

  16. Cash Flow/Tax Effects of Operating Expenses • Operating expenses are cash outflows • In general operating expenses are tax deductible • Operating expenses versus capital expenditures • Replacement reserves

  17. Cash Flow Effects of Financing • Interest and principal repayment • Financing Costs are cash outflows in year incurred • Prepayment Penalities are cash outflows in year of prepayment of mortgage

  18. Tax Effects of Financing • Interest and prepayment penalities are deductible in year incurred • Financing Costs Financing costs are amortized over the term of the loan Unamortized balance taken in the year mortgage is terminated

  19. Financing Costs Example • A real estate investor purchased a property for $850,000 and financed it with a $637,500 mortgage and $212,500 in equity. The financing costs (mortgage broker fee, legal fees, etc) were 1.5% of the amount borrowed. The mortgage was for 20 years at an interest rate of 7.0% with monthly amortization.

  20. Financing Costs Example • Total financing costs were $9,563 ($637,500)(.015) • For tax purposes the amortized deduction each year is $9,563/20 = $478 • If the loan is paid off at the end of 5 years, the unamortized balance is $7,650

  21. Annual Depreciation Deduction • Annual Depreciation Deduction = Depreciable Basis/Useful Life • Building Value • Land Value • Acquisition Costs • Not a Cash Outflow

  22. Depreciable Basis • The original cost basis includes all costs associated with acquiring the property and transferring the title • Land value cannot be depreciated—How to allocate between land and building value? • The depreciable basis is the total amount that can be depreciated over the useful life (recovery period) • Depreciable Basis = Total Costs - Land Value

  23. Cost Recovery Period/Useful Lifefor Tax Calculations • Residential Income Property (27.5 years) • Other Commercial Income Property (39 years) • Personal property (3-15 years)

  24. Depreciation Deduction Example • An investor purchased a small apartment investment at a cost of $850,000. Acquisition costs were $17,000. • What is the annual depreciation deduction on this investment?

  25. Depreciation Deduction Example • Total Cost Basis: Building Costs $680,000 Land Cost 170,000 Acquisition Costs17,000 Total $867,000

  26. Depreciation Deduction Example • Depreciable Basis Building Costs $680,000 plus 80% of Acquisition Costs 13,600 Depreciable Basis 693,600 • Depreciation deduction = 693,600/27.5 = 25,222

  27. After-Tax Cash Flows • See Small Apartment Example spreadsheet

  28. Tax Effects from Sale • The Sale of a real estate investment can create several potential tax effects: Capital Gain (loss) Depreciation Recapture Tax

  29. After-Tax Cash Flow From Sale

  30. Taxable Income from Sale

  31. Taxes Due on Sale

  32. Calculation of Adjusted Basis The original basis is “adjusted” by depreciation deductions and capital improvements Original Cost Basis - Cumulative Depreciation Deductions + Capital Improvements = Adjusted Basis

  33. Depreciation Recapture • On the sale of a real estate investment all of the depreciation deductions that have been taken are subject to a “depreciation recapture” tax.

  34. Capital Improvements • Distinction between Operating Expense and Capital Improvement. Example: Roof Repair versus Replacement • Cash Flow versus Tax Effects • Capital Improvement is depreciated whereas repair is deductible in year incurred.

  35. Types of Taxes Due on Sale • Capital Gain Taxes -- Taxed at Capital Gains Tax Rates with a maximum tax rate of 20% • Depreciation Recapture Taxes – Taxed as Ordinary Income with maximum tax rate of 25%

  36. ATER Example A real estate investor purchased an apartment project for $850,000. Acquisition costs were $17,000 and the investment was allocated 80% to the building and 20% to the land for tax purposes. The investor used straight-line depreciation over a 27.5 year life. The investment is expected to be sold at the end of five years for $924,125 with selling expenses of 4%.

  37. ATER Example • What is the expected after-tax cash flow from the sale of this investment?

  38. After-Tax Cash Flow From Sale

  39. Taxable Income and Taxes Due on Sale

  40. ATER Example • Depreciation Deduction = $867,000(.80)/27.5 = 25,222 • Cumulative Depreciation Deductions = 25,222(5) = 126,110

  41. Calculation of Adjusted Basis Original Cost Basis $867,000 - Cumulative Dep. Deductions 126,110 + Capital Improvements 0 = Adjusted Basis 740,890

  42. Taxes Due on Sale • Capital Gain Tax = 20,160(.2) = 4,032 • Dep Recap Tax = 126,110(.25) = 31,527

  43. ATCF Analysis • For the Small Apartment Investment Example, what is the NPV and IRR on equity on an after-tax basis?

  44. ATCF Analysis • How sensitive is the investment decision to the tax assumptions?

  45. Alternative ReversionStrategies • Sale versus Continue to Operate • Tax-Deferred Exchanges • Sale-Leaseback • Renovation as Alternative to Disposition • Refinancing as Alternative to Disposition

  46. Small Apartment Case Estimate the ATCFs and ATER for the Small Apartment Case. How sensitive is decision to tax assumptions? See spreadsheet solutions

  47. Cash Flow Forecasting: Review • What are the issues in forecasting cash flows? • The “science” versus the “art” of cash flow forecasting • What are the common errors in cash flow forecasting?

  48. Cash Flow Forecasting: Review • Rent growth rates: Lease-by-lease analysis, impact of long-term leases, various types of rents may grow at different rates, rent “spikes” • Vacancy losses: Competitive position of property, future supply/demand increases, tenant turnover

  49. Cash Flow Forecasting: Review • Operating expenses: Influence of building age, growth rates in expense categories • Capital expenditures: How to plan and forecast cash flow impacts • Reversion forecast: Going-out cap rate assumption, economic life of building

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