Fundamentals of Real Estate Lecture 7 Spring 2003

Fundamentals of Real Estate Lecture 7 Spring, 2003 Copyright © Joseph A. Petry www. cba. uiuc. edu/jpetry/Fin_264_sp 03

Housekeeping Issues Exam one week from today, 2/19 l MC, 30 -40 questions, similar to homework, class examples. Exam will cover ch. 1 -4. l You should read each chapter carefully as well as know lecture and homework material. 2

Federal Income Taxation Forecasting Taxable Income--At Sale l Even more so than ongoing operations, tax considerations play an important role when considering disposition of the property. l There are three basic approaches to taxes at sale 1. 2. 3 3. Fully taxable event Tax deferral via an installment sale Tax deferral via a like-kind (1031) exchange

Taxation at Sale of Property l To arrive at After-Tax Equity Reversion (ATER): – – – 4 Begin with Gross Selling Price (GSP). From GSP deduct expenses of selling the property (SE) This gives us Net Sale Proceeds (NSP), or Amount Realized Subtract Remaining Mortgage Balance (RMB) to obtain Before Tax Equity Reversion (BTER) Subtract Taxes Due at Sale (TDS) from BTER to obtain After Tax Equity Reversion (ATER)

Taxation at Sale of Property l To calculate the Taxes Due at Sale (TDS): – – Begin from NSP calculated above. Deduct Adjusted Basis (AB) to obtain the Total Taxable Gain (TG) l l AB is sometimes referred to as the “book value” of the asset AB is the undepreciated cost basis of the property less the total depreciation taken during the life of the asset. – – 5 The undepreciated cost basis is the original acquisition price (land, building, other improvements) plus acquisition costs, plus any capital improvements made after purchase. Any excess of NSP over AB is a taxable gain; any deficit is a taxable loss.

Taxation at Sale of Property – The Total Taxable Gain (TG) is divided into two parts 1. Depreciation Recapture Component – – 2. Capital Gain Component – – 6 – DR is the total amount of depreciation taken since purchase DR can be taxed as high as 25% The remainder of the TG once depreciation is deducted (CG = TG - DR) The amount the property has increased in value (net of acquisition costs) since acquisition CG can be taxed as high as 20% DR tax liability plus the CG tax liability sums to TDS ATER equals BTER less TDS

Taxation at Sale of Property 7

Taxation at Sale of Property 8

Taxation at Sale of Property 9

Taxation at Sale of Property 10

Taxation at Sale of Property l 1. 11 There are two commonly used means of deferring taxes associated with selling an income property. Installment Sale—the seller acts as the lender to the buyer. Instead of paying for cash for the building, the buyer enters into an agreement to pay for the building over time. The seller pays income tax on the sale, to the extent that the buyer pays the principal down on the loan. Unfortunately, many sellers are not keen on taking on the credit risk of someone they do not know.

Taxation at Sale of Property 12 2. Like-Kind (or 1031) Exchange. This rule is used very frequently, and allows the sellers of one property to exchange it for another “like” property. Most investment properties can be exchanged in this manner—an office building for an apartment building or retail center for example would be acceptable. You have to identify the target property within a relatively short period of time, and keep sale proceeds from the sale of the first property in escrow until the purchase takes place. Specific rules apply to timing, etc which must be adhered to carefully.

Taxation at Sale of Property 13 Example: Assume the following regarding a non-residential building: The purchase price is 450, 000. The investor obtains a 360, 000 loan. There are no financing costs. The investor expects the market value of the property to increase to $472, 500 over the anticipated two-year holding period. Selling costs are expected to be 6% of the estimated sales price. The investor is in the 28% ordinary tax bracket. Capital gains will be taxed at 20%. Assume that the balance of the loan at the time of sale will be $354, 276. Also assume that 15% of the purchase price represents the value of the land, and that improvements (the building) are depreciated over 31. 5 years using straight line depreciation. A) compute the annual depreciation deduction, B) compute the adjusted basis at the time of the sale (after two years); C) Compute the tax liability from sale; D) Compute the after-tax cash flow (equity reversion) from sale.