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

2 Exam one week from Wednesday, 2/19 MC, questions, similar to homework, class examples. Exam will cover ch 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

3 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 – 1& 2 not depreciable, 3 & 4 depreciable Federal Income Taxation--Ch 4

4 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

5 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. Federal Income Taxation

6 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. Federal Income Taxation

7 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. Federal Income Taxation

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

9 Generalized Income Tax Calculations Federal Income Taxation

10 Federal Income Taxation

11 Taxation of Ongoing Operations

12 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) Taxation of Ongoing Operations

13 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. Taxation of Ongoing Operations

14 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 = % per full year for residential; 1/39 = 2.564% for non-residential income properties. mid-month rule – Assumes property is ALWAYS bought on 15 th of month. If you purchase property Jan 3, 2002, you could deduct only 11.5 months of depreciation the first year. July 26 th, 5.5 months. Taxation of Ongoing Operations

15 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 monthly payment--which stays constant. How much is interest, how much principal? – Month 1? – Month 2? – Month 3? Taxation of Ongoing Operations

16 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 Taxation of Ongoing Operations

17 Taxation of Ongoing Operations

18 Taxation of Ongoing Operations

19 Taxation of Ongoing Operations

20 Taxation of Ongoing Operations

21 Taxation of Ongoing Operations