1. Fundamentals of Real Estate Lecture 6 Spring, 2002 Copyright © Joseph A. Petry www.cba.uiuc.edu/jpetry/Fin_264_sp02

2. 2 Exam one week from Wednesday, 2/13 MC, 30-40 questions, similar to homework, class examples. Exam will cover ch. 1-4 & 6. We will finish chapter 4 today, and dedicate Wednesday and Monday to chapter 6 and any other miscellaneous issues. HW Key is on Course Outline page of website. Late HW will not be accepted. No office hours this Wednesday. Chapter 4 HW will be posted today (Monday). Housekeeping Issues

3. 3 Cash Calculation Vs. Tax Calculation --Taxation of ongoing Operations When calculating taxes owed, adjust NOI by: – Deducting depreciation expense (DEP) – Only deducting interest expense (INT), not amortization of principal – May deduct a portion of closing related costs (legal, points) (AFC) The first two of these adjustments require further comment. Federal Income Taxation

4. 4 Cash Calculation Vs. Tax Calculation Depreciation expense is impacted by 3 things: – 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). – 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. Federal Income Taxation

5. 5 Cash Calculation Vs. Tax Calculation Depreciation expense is impacted by 3 things: – 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. Federal Income Taxation

6. 6 Cash Calculation Vs. Tax Calculation 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? Federal Income Taxation

7. 7 Cash Calculation Vs. Tax Calculation Only deduct interest expense, not amortization of principal Month 1: 8000 annual interest on 100k, monthly = 666.67. This leaves 169.77 for principal. Month 2: 7986.42 annual interest on 99,830.23, monthly = 665.53. This leaves 170.91 for principal. Month 3: 7972.75 annual interest on 99,659.32, monthly = 664.40. This leaves 172.04 for principal. Month 4: ? Month 5: ? Federal Income Taxation

8. 8 Cash Calculation Vs. Tax Calculation Once the taxable income (TI) amount is obtained, the personal income tax rate (TR) is applied. (This rate varies from 15% to 39.6%) This tax liability (TAX) is then carried over to the cash flow balance sheet, deducted from BTCF to determine After-Tax Cash Flow (ATCF). Federal Income Taxation

9. 9 Cash Calculation Vs. Tax Calculation For simplicity, we are considering this only residential for depreciation purposes. This gives us a 3.6364% deduction per year. We assume purchase on January 1. – We will also ALWAYS ignore the mid-month convention. Assume 90% of the value of this asset is attributable to the building and 10% to the land. Federal Income Taxation

10. 10 Federal Income Taxation

11. 11 Federal Income Taxation

12. 12 Federal Income Taxation

13. 13 Federal Income Taxation

14. 14 Forecasting Taxable Income--At Sale Even more so than ongoing operations, tax considerations play an important role when considering disposition of the property. There are three basic approaches to taxes at sale 1. Fully taxable event 2. Tax deferral via an installment sale 3. Tax deferral via a like-kind (1031) exchange We consider a the fully taxable event first. We continue with our ValleyBrook Village example, and assume the maximum tax rates in our calculations (20% for capital gains, 25% for depreciation recapture). Federal Income Taxation

15. 15 Federal Income Taxation

16. 16 Federal Income Taxation

17. 17 Federal Income Taxation

18. 18 Federal Income Taxation

19. 19 Forecasting Taxable Income—At Sale There are two commonly used means of deferring the tax implications associated with selling an income property. 1. 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. Federal Income Taxation

20. 20 Forecasting Taxable Income—At Sale 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. Federal Income Taxation