Session Plan

Chapter Seven:– Taxation of Income Property– The Good the Bad and 1031 Exchange– Due Diligence Analysis– ATIRR Example– Mini-Case: Sensitivity Analysis Revisited

Real Estate Tax Benefits

Depreciation Reduction Interest Expense Deduction Possible Points Deduction Tax Deferred Exchanges Deduction of Federal Taxes to obtain ATIRR

Depreciation Defined

“A reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in trade or business and of property held for the production of income”– IRS IRC Title 26, Section 4.2.2

Investor Cash Flow vs. Taxable Income

Investor Taxable Cash Flow Income

Gross Potential Income 272,000$ 272,000$ Less: Vacancy & Collection Loss 27,000$ 27,000$ Effective Gross Income 245,000$ 245,000$

Less: Operating Expenses 70,000$ 70,000$ Net Operating Income 175,000$ 175,000$ Less: Interest 88,911$ 88,911$ Points -$ 3,000$ Amortization of Principal 40,047$ -$ Depreciation -$ 46,154$ Cash Flow Before Tax 46,042$ -$ Taxable Income (Loss) 36,935$

Tax Assessed Values

Most county governments have tax info for residential and investment property on the tax assessor’s website– View parcel and improvement data– View purchase and sale data– View if owner is current on taxes– View Tax Value and annual tax requirements for

property

http://maps2.co.forsyth.nc.us/geodata_08/

Taxation of Income Producing Real Estate

Deduct federal taxes from cash flows Also deduct interest and depreciation from the pro-

forma in order to arrive at taxable income from the property

– Can deduct the total interest paid to a lender during a given year

– Points are deducted equally over the holding period (relates to length of balloon period for mortgage)

Taxable income= NOI- Interest-Depreciation Allowance

Annual Depreciation Deduction

Annual depreciation=– Depreciable basis ÷ cost recovery period

Cost Recovery Period– Residential income property (27.5 years)– Other commercial income property (39 years)– Personal Property (3-15 years)

Taxation Issues

Effective tax rate– Tax rate on the specific property– Accounting for depreciation and interest add-backs

Marginal tax rate– Tax bracket of investor including all sources of income– If property is held in a real estate holding company, and that

company is classified as either an S-Corporation or as a partnership, federal taxes are not paid at the corporate level, but in essence are passed-through to the investors…

2011 Marginal Tax Rates

Married Filing Jointly

Income Bracket Marginal Tax

Up to $17,000 10%

$17,001-$69,000 15%

$69,001-$139,350 25%

$139,351-$212,300 28%

$212,301-$379,150 33%

Over $379,150 35%

Taxation Issues: Pass-Throughs

Assume that Vic and Sal Tyan own Tyan Investments, LLC on a 50/50 basis.

Assume that the taxable income from Tyan Investments, LLC for 2011 was $410,000.

Since Vic and Sal own 50% of the partnership, each will report taxable income of $205,000 on their personal tax returns for 2011.

For 2011, this would place both Vic and Sal in the 28% marginal tax bracket, ceteris paribus.

Personal Tax Returns “Lettered Schedules”

Schedule A– State and local taxes, itemized deductions

Schedule B– Interest & Dividends (both active and passive)

Schedule C– Sole Proprietor profit and loss statement

Schedule D– Capital Gains and Losses

Schedule E– Investment Real Estate, Royalties, & Pass-through income

Schedule F– Farming Profit and Loss

Schedule K– Links with Corporate Return: shareholder capital contributions and draws– Schedule K-1 for each individual or entity with ownership interest in

corporation

What the Heck is a K-1?

Schedule K is on a corporate return– Each owner files one (K-1) to show amount

of taxable income from a passthrough entity (LLC, Partnership, etc.)

– Also shows bank how much capital was contributed and drawn by the owner for each fiscal year

Interplay of Personal and Business Tax Returns

Personal (US Form 1040) Business (US Form 1065)Line 7 Wages Lines 9 & 10 (officer salaries, guaranteed payments)Line 44 Federal Tax Line 22 Net Income (after owner salaries, Op Ex)

Lettered Schedules: Lettered Schedules:A: State/local taxes, itemized deductions L: Balance Sheet (Property & Deprec Record)B: Interest and Dividends (active/passive) K: Shareholder Draws, ContributionsC: Sole ProprietorshipD: Capital GainsE: Investment Property, Royalties, Pass-through IncomeF: Farming Profit and Loss

Interplay of Personal and Business Tax Returns

3 Forms of Taxable Income

Passive Income– Income/losses from trade or business where investor does not

actively participate in management of the company– Rental Income is considered passive

Active Income– Investor materially participates – For real estate: hotels and nursing home ownership is considered

active income (if they materially participate), the rest is considered passive

– Salaries, wages, bonuses, & commissions Portfolio Income

– Investment income (interest & dividends) where investor does not control majority ownership in the property/company

Capital Gains & Losses

Figured on Net Sales Proceeds:– Capital Gains/Losses= Gross sales price- selling

expenses-adjusted basis– Selling expenses are legal fees, recording fees, and

brokerage fees– Adjusted basis is its original basis (cost of land,

improvements, acquisition and installation fees) plus the cost of any capital improvement, alterations, or additions made during the period of ownership, less accumulated depreciation taken by the time of sale

– Pay taxes on the amount of gain on sale of real estate of up to 25% for 2010

– Unless you use those proceeds from the sale to purchase another similar property…

1031 Exchange

1031 Exchange (or Like Kind Exchange)– Both property sold and new property must be classified

either business or investment property– Have 5 days to identify a qualified intermediary– Have a 45 day inspection period once initial sale goes

through– Then have up to 180 days to find a new investment and

close on the purchase– If this is accomplished, the investor does not have to pay

taxes on the capital gains associated with the sale of the initial property

1031 Exchange

Types:– Simultaneous– Delayed/Deferred– Reverse– Improvement

Qualifications:– Meet 1031 definition– Speed– Size*– Leverage*

*Boot: Money, Debt relief, fair market value of other propertyIf trade for lower equity position, will be taxed for difference

If trade for property of lower market value, will more than likely be taxed for the difference in form of boot.

1031 Exchange

To balance equity:– Investor A

Increase loan by $100M

– Investor B Add $100M in cash Pay down mortgage by

$100M

Each represents boot and will be taxed

  Investor A Investor B

  Office Retail

Market Value

2,000,000

1,900,000

Loans (-) 1,500,000

1,500,000

Equity (=) 500,000 400,000

Difference   100,000

Balance 500,000 500,000

1031 Exchange

Zero Capital Gains Tax when:– All cash from sale is used to purchase replacement property– Replacement property purchased for at least as much as price

of relinquished property– Investor obtains same amount of financing on replacement

property as was paid out on relinquished property– Both properties meet like-kind definitions and timeframes– Equity for the properties exchanged is balanced

Tax Due on Sale

= Net Sales Proceeds- Adjusted Basis

= Total Taxable Gain- Depreciation Recapture (if used accelerated method)

= Capital Gain

….Capital Gain Tax+ Depreciation Recapture Tax (if necessary)

= Tax Due on Sale

After Tax Cash Flow From Sale

= Gross Sales Price

-Selling Expenses

= Net Proceeds from Sale

-Remaining Mortgage Balance

=Before Tax Equity Reversion

-Tax Due on Sale

=After Tax Equity Reversion

Profitability Index

Used to compare the present value of the before tax cash flows relative to the initial equity investment.

If the PV BTCF > Initial Equity Investment, the investment is “profitable” at the desired internal rate of return.

Not used much in practice

Underwriting Income Producing Properties

Most commercial banks will follow the following process:– Loan application– Obtain description of property and legal aspects– Cash Flow Estimates – Obtain Appraisal report and market feasibility

study if necessary– Specifically related to an investor, a bank will

typically require….

Putting a Package Together

Current/Prospective Rent Roll Copies of Leases & Purchase Contract 3 Years Business Tax Returns (including K-1s) 2 Years Personal Tax Returns Current Personal Financial Statement Property P&L (if not broken out in tax returns) Comment on Management Ability & Experience Prior Appraisal, Phase I, and Survey (if available)

Bank Underwriting Process

Obtain necessary financial information concerning– Historical property income and expenses– Market vacancy, rental and expense rates– Individual credit history– Individual financial strength (liquidity and net worth)– Wachovia performs direct capitalization and/or discounted

cash flow analysis to determine how much they would consider lending on a given property and customer

– The stronger the individuals, the more the lender might want to finance…

Due Diligence in RE Investment Risk Analysis

Due Diligence is the process of discovering information needed to assess whether an investment risk is suitable given the objectives of the investor & the lender

The Due Diligence period is similar to fundamental analysis for stock investments

Making sure that the investment vehicle has the adequate engine for growth & no flat tires!

Due Diligence Review Items

Property Rent Roll– Ascertain tenant mix strength and durability of income

Copies of all leases– In order to assess who pays what & is needed for income

approach valuation Historical Profit and Loss on Property Review Service & Maintenance Contracts Review Title Insurance & Deed Documents

– Make sure seller has legal right to convey ownership

Remember to Review Those Leases!

Gross/Full Service Lease– Owner pays all expenses

Modified Gross Lease– Tenant pays some expenses (a negotiation)

Absolute Net Lease (or just “Net Lease”)– Tenant pays all expenses

Triple Net Lease– Tenant pays for taxes, insurance, and maintenance

Which would have the highest rent per square foot?

Due Diligence Review Items

Review Survey of property– To see if any encroachments exist

Make sure zoning and government compliance issues are satisfactory

Physically inspect property– Investor should “kick the tires” but also hire a professional

property inspector Conduct Engineering Study

– Especially if investor has issues concerning structural soundness of property

Due Diligence Review Items

Market Study– Assess future trends in supply and demand in area

& economic trends in region

Feasibility Study– For new construction or turn-around properties– Hire appraiser to determine if demand for tenant

space is high or low in the area

Review Any Pending Legal Matters Review Tax & Insurance History on Property

ATIRR Chapter Example

Problem specifics:– Property worth $2 million, $1.8MM building value– 75% LTV, loan at 6% for 5 years for 240 months– 1% origination fee, 5 year term/holding period– Projected year 1 NOI $175M, 3% annual growth– 28% tax marginal tax bracket, 20% capital gains– Reversion at end of 5 years, 3% selling costs

Year 6 NOI ($203M), 9% terminal cap rate

Asking Price $2,000,000.00NOI Year 1 175,000$ Building Value 1,800,000$ Growth NOI 3.00% Depreciation 39 YearsLoan to Value 75.00% Ord. Income Tax 28%Loan Interest 6.00% Capital Gains Tax 20%Loan Term 20 YearsPayments per year 12Appreciation Rate 3.00%Holding Period 5 YearsSelling Costs 3.00%

Equity 500,000 Loan 1,500,000 Monthly Loan Payment 10,746 Mortgage Balance 1,273,494

Summary of Loan InformationEnd of Year 1 2 3 4 5

Payments for 12 months 128,958 128,958 128,958 128,958 128,958 Mortgage Balance at year end 1,459,953 1,417,437 1,372,297 1,324,374 1,273,494 Total interest for 12 months 88,911 86,441 83,818 81,034 78,078 Total principal reduction for 12 months 40,047 42,517 45,140 47,924 50,880

End of Year 1 2 3 4 5 Net Operating Income 175,000 180,250 185,658 191,227 196,964 Debt Service 128,958 128,958 128,958 128,958 128,958 Before Tax Cash Flow 46,042 51,292 56,700 62,270 68,006

End of Year 1 2 3 4 5 Net Operating Income 175,000 180,250 185,658 191,227 196,964 Less: Interest 88,911 86,441 83,818 81,034 78,078 Depreciation 46,154 46,154 46,154 46,154 46,154 Loan Points 3,000 3,000 3,000 3,000 3,000 Taxable Income 36,935 44,655 52,686 61,039 69,732 Tax (Savings) 10,342 12,503 14,752 17,091 19,525 After Tax Cash Flow 35,701 38,789 41,948 45,179 48,481

Sales Price 2,255,000 Sales Costs 67,650 Mortgage Balance 1,273,494 Before Tax Cash Flow 913,856

Original Cost Basis 2,000,000 Accum.Depreciation 230,769 Adjusted Basis 1,769,231

Capital Gain 418,119 Tax From Sale 83,624 After Tax CF from Sale 830,232

Year 0 1 2 3 4 5Before Tax Cash Flow (500,000) 46,042 51,292 56,700 62,270 981,862 BTIRR on Equity 21.71%

Year 0 1 2 3 4 5After Tax Cash Flow (500,000) 35,701 38,789 41,948 45,179 878,714

17.52%

Equity

AssumptionsTax Considerations

Cash Flow from Sale in Year 5

To Find Total Interest: Multiply monthly loan pmt by 12, to get annual loan payment then subtract the total principal paid for 12 months. Can use Amort Key on HP 10 B II.

NOTE:Assumes year 6 NOI of $203M divided by 9% cap rate.Alternative Methodology:Multiply asking price by 3% appreciation rate compounded for 5 years.

NOTE:Land is worth $200M, Building is worth $1.8MM.

End of Session