Fundamentals of Real Estate Lecture 6 Spring, 2003 Copyright © Joseph A. Petry

Fundamentals of Real Estate

Lecture 6

Spring, 2003

Copyright © Joseph A. Petry

www.cba.uiuc.edu/jpetry/Fin_264_sp03

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Exam one week from Wednesday, 2/19 MC, 30-40 questions, similar to homework, class

examples. Exam will cover ch. 1-4. You should read each chapter carefully as well

as know lecture and homework material. Chapter 4—Federal Income Taxation starts

today. This is an important and somewhat confusing chapter. – Tax implications for ongoing operations (today)– Tax implications at time of property sale (Wednesday)

Housekeeping Issues

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Classes of Real Property for tax purposes1) Real estate held as a personal residence

2) Real estate held for sale to others--dealer property

3) Real estate held for use in a trade or business--trade or business property

4) Real estate held as an investment for the production of income--investment property

The category establishes rules regarding depreciation and deductibility of losses from sale

– 1& 2 not depreciable, 3 & 4 depreciable

Federal Income Taxation--Ch 4

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Investment properties considered “trade or business property” NOT “investment property”. – Trade or Business Property

residential, retail, office, warehouses, etc. Fully depreciable, AND allows full immediate deductibility of

losses from sale in the year of sale.

– Investment Property Includes raw land Fully depreciable, BUT does not allow full immediate

deductibility of losses from sale in the year of sale.

Federal Income Taxation

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Types of Income Active Income

– Income earned from salaries, wages, commissions, fees, and bonuses.

– Taxed at ordinary income tax rates

Portfolio Income– Income from investments in securities, such as

interest and dividend income from stocks and bonds as well as capital gains from sale of securities.


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Types of Income Passive Activity Income

– New category established in 1987, which restricts deductibility of losses from passive activity.

– Passive income includes income generated from trade and business activities in which the taxpayer does not “materially” participate and from income generated from rental real estate.

– Consequently, all income property investments are classified as passive investments as far as Passive Activity Loss (PAL) rules are concerned.


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Passive Activity Loss (PAL) Rules– For those falling under the PAL rules, losses from real

estate rental business can only be used to shelter gains from other passive income. It cannot be used to shelter active (wages from your full-time job) or portfolio income (interest or dividends from your stock and bond holdings).

– Major shift for high income groups, that used real estate largely as a tax shelter.


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– Losses that cannot be used in one year, are banked for possible use against future passive income.

– Cumulative losses are allowed to be utilized in full at the time of sale of the property.

– There are a number of important exceptions:1. Active managers of real estate can deduct up to $25,000 of

passive income losses against non-passive income if adjusted gross income (AGI) is less than $100,000.

2. Those in “real estate property business” were relieved of these restrictions in 1993 legislation, and can use against non-passive income.


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Generalized Income Tax Calculations


General Tax Formula for Individuals

Salaries+ Business Income (Schedule C)

+/- Capital gains or losses (limited to $3,000)+ Interest income+ Dividend income

+/- Rents, royalties, and partnerships (Schedule E)= Adjusted gross income (AGI)- Itemized personal (or standard) deductions- Personal exemptions= Federal taxable income

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Single Taxpayers: 1999 Tax Rate ScheduleIf Taxable Your Tax Of the Amount

Income is Over But Not Over Liability Is Over0 25,750 15% 0

25,750 62,450 3,862 + 28% 25,75062,450 130,250 14,138 + 31% 62,450

130,250 283,150 35,156 + 36% 130,250283,150 ---- 90,200 + 39.6% 283,150

Married Taxpayers: 1999 Tax Rate ScheduleIf Taxable Your Tax Of the Amount

Income is Over But Not Over Liability Is Over0 43,050 15% 0

43,050 104,050 6,457 + 28% 43,050104,050 158,550 23,537 + 31% 104,050158,550 283,150 40,432 + 36% 158,550283,150 ---- 85,288 + 39.6% 283,150


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Taxation of Ongoing Operations

After Tax Cash FlowsNet operating income (NOI)

- Interest expense (INT)- Principal amortization (PA)= Before-tax cash flow (BTCF)- Tax liability (TAX)= After-tax cash flow (ATCF)

Taxable Liability from OperationsNet Operating Income (NOI)

- Depreciation (DEP)- Interest expense (INT)- Amortized financing costs (AFC)= Taxable income (TI)x Tax rate (TR)= Tax liability (TAX)

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Cash Calculation Vs. Tax Calculation– Cash flow calculations and tax calculations are not identical. – If they were, calculating the tax liability from ongoing operations

would be as easy as applying the applicable tax rate to the BTCF item in the first table in the previous graph.

– While a lot easier to calculate, it would destroy a major advantage of real estate: depreciation expense

When calculating taxes owed, adjust NOI by:– Deducting depreciation expense (DEP)– Only deducting interest expense (INT), not amortization of

principal– Deduct a portion of closing related costs (legal, points) (AFC)


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Depreciation expense is impacted by 3 things:1. the amount of the depreciable base, or cost basis

original cost basis is the acquisition price of the land & building.

From this deduct the land portion (doesn’t wear out). Land usually represents 10-30% of the value of the asset.

Add expenses associated with the purchase (points, legal).

2. cost recovery period of the asset residential income property depreciated over no less than

27.5 years non-res. property depreciated over no less than 39 years.


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3. allowable method of depreciation straight line depreciation is only method allowable at present accelerated depreciation was allowed, and still is on some

minor portions of purchase (personal property for instance, carpet, appliances--anything that is not permanently affixed to the structure).

straight line rate = 1/recovery period 1/27.5 = 3.6364% per full year for residential;

1/39 = 2.564% for non-residential income properties. mid-month rule

– Assumes property is ALWAYS bought on 15th of month. If you purchase property Jan 3, 2002, you could deduct only 11.5 months of depreciation the first year. July 26th, 5.5 months.


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Only deduct interest expense, not amortization of principal– This requires you to break loan payments into the two

components; interest payment, principal amortization. 20 year, $100,000 loan, 8% interest, monthly installments. 836.44 monthly payment--which stays constant. How much is interest, how much principal?

– Month 1?– Month 2?– Month 3?


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Obtaining After-Tax Cash Flow (ATCF) After NOI is properly adjusted as indicated above, we are left with

taxable income (TI) from operations Apply the personal income tax rate (TR) to obtain the Tax liability

(TAX). – Income tax rate varies by individual from 15% to 39.6% depending upon

the level of adjusted gross income (AGI) discussed earlier. The tax liability (TAX) is then carried over to the cash flow balance

sheet, deducted from BTCF to determine After-Tax Cash Flow (ATCF).

Campus Apartments Example:– Assume Jan 1 purchase– See additional assumptions


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Campus Apartments Campus ApartmentsInput Assumptions Reconstructed Operating Statement

Input AssumptionAsking Purchase Price 4,000,000

Land value 400000 10% of total priceNumber of residential units 25 1200 sq ft eachResidential Rents 1,800$ per unit, per monthNumber of rental parking spaces 50 spacesParking Rents 60$ per monthProjected Rental Increase 2% per yearVacancy and Collection Losses 10% per yearOperating Expenses -0.39 of gross rentsExpected Holding Period 10 yearsExpected Selling Price 4,800,000$ 2.0% per yearSelling Expenses 2.50% of sale priceMortgage Financing:

Loan-to-Value ratio 80% of construction costsInterest Rate 7%Maturity 25 yearsUp-front Financing Costs 0% points

Personal Income Tax Rate 28%

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Amortization Table for Campus Apartments Interest & Depreciation Expense CalculationMonth Total Payment Principal Interest RMB

1 $22,616.93 $3,950.27 $18,666.67 $3,196,049.732 $22,616.93 $3,973.31 $18,643.62 $3,192,076.423 $22,616.93 $3,996.49 $18,620.45 $3,188,079.934 $22,616.93 $4,019.80 $18,597.13 $3,184,060.135 $22,616.93 $4,043.25 $18,573.68 $3,180,016.886 $22,616.93 $4,066.84 $18,550.10 $3,175,950.057 $22,616.93 $4,090.56 $18,526.38 $3,171,859.498 $22,616.93 $4,114.42 $18,502.51 $3,167,745.079 $22,616.93 $4,138.42 $18,478.51 $3,163,606.64

10 $22,616.93 $4,162.56 $18,454.37 $3,159,444.0811 $22,616.93 $4,186.84 $18,430.09 $3,155,257.2412 $22,616.93 $4,211.27 $18,405.67 $3,151,045.9713 $22,616.93 $4,235.83 $18,381.10 $3,146,810.1414 $22,616.93 $4,260.54 $18,356.39 $3,142,549.6015 $22,616.93 $4,285.39 $18,331.54 $3,138,264.20

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Interest & Depreciation Expense CalculationAfter year Interest Principal RMB Depreciation

1 $222,449.18 $48,954.03 $3,151,045.97 125,454.55 2 $218,910.29 $52,492.92 $3,098,553.05 130,909.09 3 $215,115.57 $56,287.64 $3,042,265.42 130,909.09 4 $211,046.54 $60,356.67 $2,981,908.74 130,909.09 5 $206,683.35 $64,719.86 $2,917,188.88 130,909.09 6 $202,004.74 $69,398.47 $2,847,790.41 130,909.09 7 $196,987.92 $74,415.29 $2,773,375.12 130,909.09 8 $191,608.44 $79,794.78 $2,693,580.34 130,909.09 9 $185,840.07 $85,563.15 $2,608,017.20 130,909.09

10 $179,654.70 $91,748.51 $2,516,268.69 130,909.09

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Taxable Liability from Operations After-Tax Cash Flow from OperationsYear =NOI -DEP -INT -AFC =TI xTR =TAX

1 317,607.16$ ($125,455) ($222,449) 0 (30,296.57)$ 28% $02 323,959.30$ ($130,909) ($218,910) 0 (25,860.08)$ 28% $03 330,438.49$ ($130,909) ($215,116) 0 (15,586.18)$ 28% $04 337,047.26$ ($130,909) ($211,047) 0 (4,908.37)$ 28% $05 343,788.20$ ($130,909) ($206,683) 0 6,195.76$ 28% ($1,735)6 350,663.97$ ($130,909) ($202,005) 0 17,750.13$ 28% ($4,970)7 357,677.25$ ($130,909) ($196,988) 0 29,780.23$ 28% ($8,338)8 364,830.79$ ($130,909) ($191,608) 0 42,313.26$ 28% ($11,848)9 372,127.41$ ($130,909) ($185,840) 0 55,378.25$ 28% ($15,506)10 379,569.95$ ($130,909) ($179,655) 0 69,006.16$ 28% ($19,322)

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After-Tax Cash Flow from Operations Calculating Cash Flow from SaleYear =NOI -INT -PA =BTCF -TAX =ATCF

1 317,607.16$ ($222,449.18) ($48,954.03) 46,203.95$ $0 46,203.95$ 2 323,959.30$ ($218,910.29) ($52,492.92) 52,556.09$ $0 52,556.09$ 3 330,438.49$ ($215,115.57) ($56,287.64) 59,035.28$ $0 59,035.28$ 4 337,047.26$ ($211,046.54) ($60,356.67) 65,644.05$ $0 65,644.05$ 5 343,788.20$ ($206,683.35) ($64,719.86) 72,384.99$ ($1,735) 70,650.18$ 6 350,663.97$ ($202,004.74) ($69,398.47) 79,260.75$ ($4,970) 74,290.72$ 7 357,677.25$ ($196,987.92) ($74,415.29) 86,274.03$ ($8,338) 77,935.57$ 8 364,830.79$ ($191,608.44) ($79,794.78) 93,427.58$ ($11,848) 81,579.86$ 9 372,127.41$ ($185,840.07) ($85,563.15) 100,724.19$ ($15,506) 85,218.28$

10 379,569.95$ ($179,654.70) ($91,748.51) 108,166.74$ ($19,322) 88,845.02$

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Fundamentals of Real Estate Lecture 6 Spring, 2003 Copyright © Joseph A. Petry