Transcript Stone Arch Village

Fundamentals of Real Estate
Lecture 6
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
Housekeeping Issues
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.
–
2
–
Tax implications for ongoing operations (today)
Tax implications at time of property sale (Wednesday)
Federal Income Taxation--Ch 4

Classes of Real Property for tax purposes
1) 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
–
3
1& 2 not depreciable, 3 & 4 depreciable
Federal Income Taxation

Investment properties considered “trade or
business property” NOT “investment property”.
–
Trade or Business Property


–
Investment Property


4
residential, retail, office, warehouses, etc.
Fully depreciable, AND allows full immediate deductibility of
losses from sale in the year of sale.
Includes raw land
Fully depreciable, BUT does not allow full immediate
deductibility of losses from sale in the year of sale.
Federal Income Taxation
Types of Income
 Active Income
–
–

Portfolio Income
–
5
Income earned from salaries, wages, commissions,
fees, and bonuses.
Taxed at ordinary income tax rates
Income from investments in securities, such as
interest and dividend income from stocks and bonds
as well as capital gains from sale of securities.
Federal Income Taxation
Types of Income
 Passive Activity Income
–
–
–
6
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.
Federal Income Taxation

Passive Activity Loss (PAL) Rules
–
–
7
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.
Federal Income Taxation
–
–
–
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.
2.
8
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.
Those in “real estate property business” were relieved of
these restrictions in 1993 legislation, and can use against
non-passive income.
Federal Income Taxation
Generalized Income Tax Calculations
General Tax Formula for Individuals
+
+/+
+
+/=
=
9
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
Federal Income Taxation
Single Taxpayers: 1999 Tax Rate Schedule
If Taxable
Your Tax
Of the Amount
Income is Over But Not Over
Liability Is
Over
0
25,750
15%
0
25,750
62,450
3,862 + 28%
25,750
62,450
130,250
14,138 + 31%
62,450
130,250
283,150
35,156 + 36%
130,250
283,150
---90,200 + 39.6%
283,150
10
Married Taxpayers: 1999 Tax Rate Schedule
If Taxable
Your Tax
Of the Amount
Income is Over But Not Over
Liability Is
Over
0
43,050
15%
0
43,050
104,050
6,457 + 28%
43,050
104,050
158,550
23,537 + 31%
104,050
158,550
283,150
40,432 + 36%
158,550
283,150
---85,288 + 39.6%
283,150
Taxation of Ongoing Operations
After Tax Cash Flows
Net operating income (NOI)
=
=
11
Interest expense (INT)
Principal amortization (PA)
Before-tax cash flow (BTCF)
Tax liability (TAX)
After-tax cash flow (ATCF)
=
x
=
Taxable Liability from Operations
Net Operating Income (NOI)
Depreciation (DEP)
Interest expense (INT)
Amortized financing costs (AFC)
Taxable income (TI)
Tax rate (TR)
Tax liability (TAX)
Taxation of Ongoing Operations
Cash Calculation Vs. Tax Calculation
–
–
–

When calculating taxes owed, adjust NOI by:
–
–
–
12
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
Deducting depreciation expense (DEP)
Only deducting interest expense (INT), not amortization of
principal
Deduct a portion of closing related costs (legal, points) (AFC)
Taxation of Ongoing Operations

Depreciation expense is impacted by 3 things:
1.
the amount of the depreciable base, or cost basis



2.
cost recovery period of the asset


13
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).
residential income property depreciated over no less than
27.5 years
non-res. property depreciated over no less than 39 years.
Taxation of Ongoing Operations
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
–
14
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.
Taxation of Ongoing Operations

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?
15
Taxation of Ongoing Operations
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).
–


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:
–
–
16
Income tax rate varies by individual from 15% to 39.6% depending upon
the level of adjusted gross income (AGI) discussed earlier.
Assume Jan 1 purchase
See additional assumptions
Taxation of Ongoing Operations
17
Campus Apartments
Input Assumptions
Input
Assumption
Asking Purchase Price
4,000,000
Land value
400000 10%
of total price
Number of residential units
25 1200 sq ft each
Residential Rents
$
1,800 per unit, per month
Number of rental parking spaces
50 spaces
Parking Rents
$
60 per month
Projected Rental Increase
2% per year
Vacancy and Collection Losses
10% per year
Operating Expenses
-0.39 of gross rents
Expected Holding Period
10 years
Expected Selling Price
$ 4,800,000 2.0%
per year
Selling Expenses
2.50% of sale price
Mortgage Financing:
Loan-to-Value ratio
80% of construction costs
Interest Rate
7%
Maturity
25 years
Up-front Financing Costs
0% points
Personal Income Tax Rate
28%
Taxation of Ongoing Operations
Month
18
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Amortization Table for Campus Apartments
Total Payment
Principal
Interest
$22,616.93
$3,950.27
$18,666.67
$22,616.93
$3,973.31
$18,643.62
$22,616.93
$3,996.49
$18,620.45
$22,616.93
$4,019.80
$18,597.13
$22,616.93
$4,043.25
$18,573.68
$22,616.93
$4,066.84
$18,550.10
$22,616.93
$4,090.56
$18,526.38
$22,616.93
$4,114.42
$18,502.51
$22,616.93
$4,138.42
$18,478.51
$22,616.93
$4,162.56
$18,454.37
$22,616.93
$4,186.84
$18,430.09
$22,616.93
$4,211.27
$18,405.67
$22,616.93
$4,235.83
$18,381.10
$22,616.93
$4,260.54
$18,356.39
$22,616.93
$4,285.39
$18,331.54
RMB
$3,196,049.73
$3,192,076.42
$3,188,079.93
$3,184,060.13
$3,180,016.88
$3,175,950.05
$3,171,859.49
$3,167,745.07
$3,163,606.64
$3,159,444.08
$3,155,257.24
$3,151,045.97
$3,146,810.14
$3,142,549.60
$3,138,264.20
Taxation of Ongoing Operations
After year
1
2
3
4
5
6
7
8
9
10
19
Interest & Depreciation Expense Calculation
Interest
Principal
RMB
Depreciation
$222,449.18
$48,954.03
$3,151,045.97
125,454.55
$218,910.29
$52,492.92
$3,098,553.05
130,909.09
$215,115.57
$56,287.64
$3,042,265.42
130,909.09
$211,046.54
$60,356.67
$2,981,908.74
130,909.09
$206,683.35
$64,719.86
$2,917,188.88
130,909.09
$202,004.74
$69,398.47
$2,847,790.41
130,909.09
$196,987.92
$74,415.29
$2,773,375.12
130,909.09
$191,608.44
$79,794.78
$2,693,580.34
130,909.09
$185,840.07
$85,563.15
$2,608,017.20
130,909.09
$179,654.70
$91,748.51
$2,516,268.69
130,909.09
Taxation of Ongoing Operations
Year
1
2
3
4
5
6
7
8
9
10
20
=NOI
$ 317,607.16
$ 323,959.30
$ 330,438.49
$ 337,047.26
$ 343,788.20
$ 350,663.97
$ 357,677.25
$ 364,830.79
$ 372,127.41
$ 379,569.95
Taxable Liability from Operations
-DEP
-INT
-AFC
=TI
($125,455) ($222,449)
0
$ (30,296.57)
($130,909) ($218,910)
0
$ (25,860.08)
($130,909) ($215,116)
0
$ (15,586.18)
($130,909) ($211,047)
0
$ (4,908.37)
($130,909) ($206,683)
0
$ 6,195.76
($130,909) ($202,005)
0
$ 17,750.13
($130,909) ($196,988)
0
$ 29,780.23
($130,909) ($191,608)
0
$ 42,313.26
($130,909) ($185,840)
0
$ 55,378.25
($130,909) ($179,655)
0
$ 69,006.16
xTR
28%
28%
28%
28%
28%
28%
28%
28%
28%
28%
=TAX
$0
$0
$0
$0
($1,735)
($4,970)
($8,338)
($11,848)
($15,506)
($19,322)
Taxation of Ongoing Operations
Year
1
2
3
4
5
6
7
8
9
10
21
$
$
$
$
$
$
$
$
$
$
=NOI
317,607.16
323,959.30
330,438.49
337,047.26
343,788.20
350,663.97
357,677.25
364,830.79
372,127.41
379,569.95
After-Tax Cash Flow from Operations
-INT
-PA
=BTCF
($222,449.18) ($48,954.03) $ 46,203.95
($218,910.29) ($52,492.92) $ 52,556.09
($215,115.57) ($56,287.64) $ 59,035.28
($211,046.54) ($60,356.67) $ 65,644.05
($206,683.35) ($64,719.86) $ 72,384.99
($202,004.74) ($69,398.47) $ 79,260.75
($196,987.92) ($74,415.29) $ 86,274.03
($191,608.44) ($79,794.78) $ 93,427.58
($185,840.07) ($85,563.15) $ 100,724.19
($179,654.70) ($91,748.51) $ 108,166.74
-TAX
$0
$0
$0
$0
($1,735)
($4,970)
($8,338)
($11,848)
($15,506)
($19,322)
$
$
$
$
$
$
$
$
$
$
=ATCF
46,203.95
52,556.09
59,035.28
65,644.05
70,650.18
74,290.72
77,935.57
81,579.86
85,218.28
88,845.02