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2:53.Types of real estate returnTax benefitsCase..., Real Estate Investor's...

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Real Estate Investor's Deskbook 2:53 (3d ed.)

Real Estate Investor's DeskbookDatabase updated May 2014

Alvin ArnoldChapter 2. Valuing Real Estate and Return on Investment

Correlation Table References

2:53. Types of real estate returnTax benefitsCase study: Cash flow sheltered by tax losses

Table 2.4 illustrates how an apartment building investment can generate a positive cash flow (dollars in the owner's pocket)and at the same time show a tax loss. The implication of a tax loss is twofold: because the property is not showing a taxablegain, all of the cash flow from the property itself is received tax free, and the tax loss itself may be used to offset other incomeof the investor and the tax savings thereby achieved is added to the cash flow from the investment itself.

TABLE 2.4 Apartment Building InvestmentA. Investment TermsPurchase price $1,200,000First mortgage loan (10 percent interest; 11.6 percent constant; twentyyears)

$650,000

Second mortgage loan (14 percent interest; no amortization) 150,000Cash down 400,000B. First-Year Cash Flow StatementGross income $210,000Vacancy8 percent 16,800Effective gross income $193,200Operating expenses 84,000Net operating income $109,200Debt service:First mortgage $75,400Second mortgage 21,000Less: total debt payments 96,400Cash flow $12,800C. First-Year Tax (Profit-and-Loss) StatementNet operating income $109,200Interest on first mortgage $65,000Interest on second mortgage 21,000Less total interest 86,000Net income after interest $23,200Depreciation (on $1,000,000 building cost) (3.64 percent) 36,400Taxable profit (loss) $(13,200)Or Another Way to Derive Taxable Profit (Loss)C. First-Year Tax StatementCash flow $12,800Add back:First mortgage amortization 10,400Total 23,200Deduct:Depreciation 36,400Taxable profit (loss) $(13,200)

Myers, Sean 7/8/2014For Educational Use Only

2:53.Types of real estate returnTax benefitsCase..., Real Estate Investor's...

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In the example given here, the investor receives a positive cash flow in the first year of $12,800 and, in addition, generatesa tax loss of $13,200. Assuming the investor is in the 36% bracket, the loss gives him an additional benefit of $4,752. (Weassume that under an exception to the passive activity loss rules, the investor can use the tax loss to offset other income.)Thus, his total return (cash flow plus tax savings) is $17,552, which represents just under a 4.4% return on the cash investmentof $400,000. This unusually low returnone normally not acceptable to an investoris necessary in this example in orderto show how a tax loss is achievable under the long recovery (depreciation) periods required by the current tax law.Table 2.4 is divided into three sections (Section C is shown in two different ways). Section A (Investment Terms) sets forththe manner in which the total purchase price is paid. In this example, the investor puts one-third cash down and raises thebalance of the price with two mortgages. The first mortgage, at 10% interest and with annual debt service equal to 11.6% ofthe total loan, will fully amortize (be paid off) in 20 years. Because we assume a fixed-rate loan, it is likely that the lenderwill retain the right to call the loan after five or 10 years in order to protect his position if interest rates increase sharply.The second mortgage loan, at a significantly higher interest rate but calling for no amortization during its term, is likely tobe a purchase-money mortgage (i.e., one taken back by the seller) as an inducement to the buyer to purchase the property.Normally, such a loan will mature in a fairly short time (e.g., five years), and the purchaser must face the problem of arrangingnew financing at that time. The purchaser assumes that increased cash flow from the property will permit him to refinanceboth the first and second mortgages at that time into a single mortgage. However, this is far from being assured and representsone of the significant risks when utilizing financial leverage in real estate. (See infra 2:62 to 2:67.)Section B of Table 2.4 (First-Year Cash Flow Statement) shows that at the end of the first year, the investor will receive acash flow of $12,800. This figure is developed in two steps. First, NOI is calculated. This represents gross rental income(assuming 100 percent occupancy), which is then reduced by a vacancy allowance based on the forecast of actual occupancy,and operating expenses. Then the debt service on the two mortgages is deducted from NOI. What remains is the cash flow,or dollars available to the investor at the end of the year.Section C (First-Year Tax Statement) begins with the same NOI figure as in Section B. However, because loan amortizationis not a tax deduction, only the interest payments on the two mortgages may be deducted for tax purposes. (The differencebetween the total interest deductions in Section C and the debt service in Section B is $10,400, which is the amortization onthe first mortgage during the year (1.6 percent of $650,000). There is no amortization of the second mortgage.)In addition to the interest deduction, the investor may take a depreciation deduction on the building but not on the land (whichis not depreciable). Since depreciation is a noncash outlay, no depreciation deduction is shown in Section B, where cash flowwas calculated. In this section, we assume that $1 million of the $1.2 million purchase price is allocated to the building and$200,000 is allocated to the land. Applying straight-line depreciation with a 27.5-year recovery period as required by the taxlaw, the investor may deduct $36,400 on his tax return. He simultaneously reduces his tax basis in the property by the sameamount (see 7:9 to 7:33). The combined deductions for interest and depreciation results in a tax loss of $13,200, whichrepresents a tax saving of $4,752 for an investor in the 36% bracket.The alternate Section C of Table 2.4 shows another shorthand way to compute the tax loss. Here, we begin with the cashflow of $12,800 (from Section B) and then do the following:

Add back the first mortgage amortization of $10,400 (a nondeductible cash expense) and

Subtract the depreciation of $36,400 (a noncash deduction).

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