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Session Plan

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

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Session Plan

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  1. 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

  2. Real Estate Tax Benefits • Depreciation Reduction • Interest Expense Deduction • Possible Points Deduction • Tax Deferred Exchanges • Deduction of Federal Taxes to obtain ATIRR

  3. 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

  4. Investor Cash Flow vs. Taxable Income

  5. 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/

  6. 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

  7. 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)

  8. 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…

  9. 2011 Marginal Tax Rates Married Filing Jointly

  10. 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.

  11. 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

  12. 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

  13. Interplay of Personal and Business Tax Returns

  14. 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

  15. 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…

  16. 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

  17. Types: Simultaneous Delayed/Deferred Reverse Improvement Qualifications: Meet 1031 definition Speed Size* Leverage* 1031 Exchange *Boot: Money, Debt relief, fair market value of other property If 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.

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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….

  24. 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)

  25. 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…

  26. 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!

  27. 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

  28. 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?

  29. 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

  30. 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

  31. 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

  32. End of Session

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