課程8: COMMERCIAL PROPERTY INVESTMENTS: PASSIVE LOSS LIMITATION, REHABILITION ANALYSIS, INVESTMENTS TAX CREDIT, LEVERAGE ANALYSIS

Income Classes: Passive Activity Loss Limitation This classification affects the extent to which the investor can shelter other income from taxes Passive Income income where the investor does not materially participate in the management; real estate falls into this category Active Income income where the investor materially participates in management. Portfolio Income all interest and dividend income received from stocks and bonds

Tax Consequences of Passive Activity Loss Limitation Passive losses from real estate investment can only be used to offset income from other passive activity PAL- PIG relationship For every Passive Activity Loss (PAL) there must be a Passive Income Generator (PIG) any left over loss is carried forward to the next period

Sale of Passive Activity Investment Passive Activity sold at a gain with a carried forward loss offset any capital gain from the sale with carried forward loss. use any leftover to offset other passive income use leftover to offset any other income including portfolio income earned during that year Passive activity with loses carried forward and sold at a loss any unused loss carried forward used to offset any income (passive, active, portfolio) $3,000 of capital loss portion may be used to offset any income

Special Exceptions to PALL Designed to benefit small time operators of rental real estate Active Participation 10% or more ownership in the real estate involvement in management decisions Active Investor can offset active income with passive loss up to $25,000 The special exception is phased when income reaches certain level

Phase Out Rule Applies to individuals with adjusted gross income of between $100,000 to $150,000. The $25,000 loss allowance is reduced by 50% of the amount the individual’s AGI for the taxable year exceeds $100,000 Allowance is completely phased out when AGI reaches $150,000 Illustration AGI = $130,000 Reduction in allowance = (130,000 - 100,000)(.5) = $15,000. Useable Passive loss = $10,000 (25,000-15,000)

Application of PALL Taxable Income and Before Tax Cash Flow ATCF assuming other PIG Marginal Tax rate at 28%

Application of PALL ATCF assuming no other PIG

Notes on use of passive loss Year two accumulated loss = -$22,000 No taxes paid in year 3 although TI is positive, accumulated loss of -$22,000 exceeds $8,000 of TI. Accumulated loss now reduced to -$14,000 = -$22,000 + $8,000 Year 4 no taxes paid even though TI = $10,000, Accumulated loss reduced to -$4,000 = -$14,000 + $10,000 Remaining -$4,000 loss is used to first reduce any gain from sale at end of year 4.

Application of PALL Using Accumulated Loss to reduce capital gain

At Risk Rule limits the extent to which losses can be deducted regardless of the existence of any passive income amounts considered to be at risk: cash contribution to the investment. adjusted basis of any property contributed. any loan in connection for which the investor tax payer is personally liable third party loans for which the investor is not personally liable

Low Income Housing Tax Credit Designed to encourage investment in low-income housing Unit Qualification expenditure for construction must exceed $2,000 per low-income unit. Project or Property Qualification at least 20% of the tenants must have income that is 50% or less of the area median income or at least 40% of the tenants must have income that is 60% or less of the median income of the area.

Rehabilitation Tax Credit The Rehabilitation Tax Credit as part of the Revenue Act of 1978. Provide incentive for developers to rehabilitate and modernize existing buildings. The tax credit can be directly applied to reduce income tax

Rehabilitation Tax Credit Credits 10 percent of rehabilitation expenses for nonresidential structures originally placed in service before 1936 20% percent of rehabilitation expenses for Certified Historic Structures The credit available in the year the property is placed in service The depreciable base of the property is reduced by the full amount of the credit taken. If the property is sold during the first five years after the rehab some of the credit will be recaptured

Application of Rehab Tax Credit When rehabilitation tax credit is taken, the depreciable basis of the property must be reduced by the full amount of the tax credit Example: Assume that Smith purchased a 50-year old nonresidential building for $1.2 million in January 1987. He spends $2 million to restore it and places the rehabilitated building in service in January 1988

Application of Rehab. Tax Credit Tax credit in 1988: (.10)(2,000,000) = $200,000 Depreciation deductions nondepreciable land : $200,000 depreciable structure : $1 million depreciation Basis = $1,200,000 + $2,000,000 - $200,000 (credit) -$200,000 (land) = $2,800,000 depreciation deduction $88,900 = (1/31.5)(2,800,000) Note: Why did we use useful life of 31.5 and not 39 years?

Recapture of tax credit If the rehab credit is taken and the property is sold during the first five years some of the credit is recaptured Year of disposition % Recapture one full year in service 100% second year 80% third year 60% fourth year 40% fifth year 20%

Further analysis of Investment Tax Credit With Recapture Investor's AGI < $100,000 Holding period = 3 YEARS Cost of rehabilation = $100,000 Type of use = office building Amount of credit = (100,000)(.1) = $10,000 Marginal tax rate = 28%

Analysis tax credit recapture 1 2 3 BTCF $60,000 $65,000 $70,000 TI norehab $40,000 $45,000 $48,000 TI (rehab. cost depreciated) $37,436 $42,436 $45,436 Taxes due $10,482 $11,882 $12,722 additional depreciation = 100,000/39 =$2,564

Analysis of tax credit recapture Assuming Rehab tax credit is taken Rehab. investment tax credit = (100,000)(.1) = $10,000 Dep. basis = 100,000-10,000 = $90,000 Additional depreciation deduction = 90,000/39= $2,308 1 2 3 TI $37,692 $42,692 $45,692 GROSS TAX DUE 10,554 11,954 12,793 LESS CREDIT 10,000 0 0 NET TAX DUE $553 $11,954 $12,793

Analysis of investment tax credit After tax cash flow with investment tax credit 1 2 3 BTCF $60,000 $65,000 $70,000 NET TAX DUE 553 11,954 12,793 ATCFw/ITC $59,447 $53,046 $57,207 After tax cash flow if ITC is not taken 1 2 3 BTCF $60,000 $65,000 $70,000 TAX DUE 10,482 11,882 12,722 ATCFwo/ITC $49,518 $53,118 $57,278

Analysis of ITC. Recapture at the end of the three year holding period = (10,000)(.6) = $6,000 SP = $500,000 SP = $500,000 -SE = 10,000 - SE = 10,000 = NSP = 490,000 = NSP = 490,000 -ADJ = 420,000 - MB = 250,000 =CG = 70,000 - BTNR = 240,000 -TD @28% = .28 - TDS = 19,600 = TDS = $19,600 less ITC recapture @60% = 6,000 = ATNR = $214,400

Valuation of Rehabilitation Credit The present value of the tax credit The present value of the foregone tax deductions The present value of capital gains taxes

ITC valuation model 1 n 1 - ----- tb$1(1 - ---) b$1 tb$1 (1 + r)n N NPV = ---- - -------- (----------------) - ------------- (1+r) N r (1 + r)n where: b = rehabilitation tax credit t = marginal income tax rate of the investor N = useful life for depreciation purposes n = holding period (n < or = N) r = after-tax required rate of return on equity

Application of ITC valuation Model Marginal Tax rate= 28%, N=31.5, n=6 , Vn > V0

Investment Tax Credit:Tax Offseting Can be used only to offset tax on passive income, but with a partial exception of $25,000 for non passive activity income The partial exception of $25,000 begins to phase-out when AGI of the tax payer reaches $200,000 and terminates once AGI reaches $250,000

Example 36% tax bracket with AGI= $200,000 Limited partner in a rehabilitation syndicate Share of the rehab tax credit = $12,000 Amount of credit to apply to non-passive activity = (.36)(25,000) = $9,000. $9,000 of the $12,000 rehab tax credit can be applied to offset taxes on non-passive activity income $3,000 = ($12,000-$9,000) can be used to offset taxes on passive income

What constitute substantial rehabilitation? Rehab tax credit is limited to cases where the rehab expenditure constitute substantial rehabilitation Substantial Rehabilitation Rehabilitation expenses during a two-year period the expenses are at least $5,000 The expenses exceed the adjusted basis of the property as of the beginning of the period

Rehabilitation Risks Construction risks Location risks Rent-up and leasing risks Financing risks Tax Risks

Estimation of Market Value Market value is a key consideration in mortgage lending and investing in income producing real estate Investors rely on market value as initial screening device in investment decision Market value also forms the basis for real estate tax assessment and compensation in case of eminent domain Three approaches to estimating market value Cost Approach Direct Sales Comparison Approach Income Capitalization Approach

Market Value and Investment Value specific investor objective of investor constraint of investor tax situation Market value average market participant average market parameters objective of average market participant taxes not directly considered market value is creature or composite of all investors

Relation between Market Value and Investment Value If investor’s discount rate is higher than the market’s, investment value will be lower than market value, holding constant cash flow If investor’s time preference is lower than the market’s, investment value will be higher than market value, ceteris paribus If the rate of discount for the investor is equal to that of the market, market value will equal investment value What is the implication of these relationships on real estate investment strategy?

Income Capitalization Approach The income capitalization approach is the most meaningful approach in valuing income-producing properties Premise: market value of real estate is the capitalized value of anticipated or expected income stream The basic model is as follows: V = I/R WHERE: V = market value I = net operating income (NOI) R = capitalization rate or cap rate for short The term capitalization refers to conversion of income into market value

Developing Net Operating Income Potential Gross Income less Vacancy and Bad Debt Effective Gross Income Operating expenses wages utilities management real estate tax insurance maintenance/repairs Replacement Reserve Net Operating Income (stabilized Net Operating Income)

Implementing the Income Capitalization Approach (1) Direct Capitalization To apply this technique one needs a sample of comparable recently sold, from which the capitalization rate is extracted as follows: A B C D Sale price $3,250,000 $3,500,000 $3,350,000 $3,200,000 NOI $346,125 $390,250 $325,000 $310,250 Cap rate 10.65% 9.94% 10.31% 10.31% Suggested cap rate = 10.42% Estimated NOI of subject property = $338,000 Market value of subject property = $338,000/.1042 = $3,243,762

The Band of Investment Technique This technique develops a cap rate by recognizing that the typical real estate capital structure is made of debt and equity It develops a cap rate based on the proportion of debt and equity and their respective required returns as follows: R = (L/V)(MC) + (1 - L/V)(EDR) where L/V = loan-to-value ratio, EDR = equity dividend rate MC = mortgage constant Assume L/V = 70%, interest rate = 11.0%, Term = 20 years, EDR = 9% R = (.70)(.0103222x12) + (.3)(.085) = .1122 or 11.22% Estimated market value = $338,000/.1122 = $3,012,477

Further Analysis using Band of Investments Technique Indicated Mortgage Amount = (.7)(3,012,477) = $2,108,734 Debt Service = $2,108,734 x .0103222 x12 = $261,201.29 BTCF = $338,000 - $261,201 = $76,799 Indicated Equity Amount = (.3)(3,012,477) = $903,743 Equity Dividend Rate (EDR) = 76,799/903743 = .08497 OR 8.5% NOTE: EDR is a current yield. Hence does not reflect property appreciation Estimated property value may not really indicate total return to investor Hold period is not considered

The Present value method Steps Project NOI over typical holding period Estimate resale price at end of holding period Discount (1) and (2) to arrive at market value V = NOI1/(1+r)1 + NOI2/(1+r)2 + ......+ NOIn/(1+r)n + [(1+g)n x V]/(1+r)n where r = discount rate for “free and clear” property; n = typical holding period, g = growth rate of income and property value See page 291 for illustration of this technique

Present value method with income in perpetuity Income and property value are changing at the same rate V = NOI1/(r - g) where g = growth of income which is equal to rate of appreciation of property value Assume investors discount rate = 13%, and g = 2.5% NOI1 = $338,000 Property’s economic = 80 years (equivalent to holding the property to perpetuity) V = $338,000/(.13 - .025) = $3,219,047 Note: If we assume a specific holding period instead of perpetuity, which is more realistic, the estimated market value should be essentially the same. See illustration next page

Present value method with shorter holding period In most cases the valuation is done assuming a holding period. Assume the investor plans to hold the investment for 5 years. What is the estimated market value? V = {[1 - (1+g)n/(1+r)n]/(r- g)}x NOI1+ [(1+g)n x V]/(1+r)n The above equation indicates that the present value of NOI growing at the rate “g” plus PV of proceeds from resale at end of holding period equals market value n = 5 years; g = 2.5%; discount rate = 13%; resale price = (1+g)n.V V = {[1 - (1.025)5/(1.13)5]/(.13 - .025)}x $338,000 + [(1.025)5 x V]/(1.13)n V = 3.675399533 x $338,000 + .614083049V .385917V = 1,242,285 ; V = $3,219,047 (compare with previous page answer)

Mortgage Equity Technique The mortgage equity technique assumes Market value (V) = Present value of debt (D) + Present value of cash flow to equity (E) Cash flow to equity has two components Before tax cash flow (BTCF) from operation Before tax net reversion(BTNR) from sale of asset BTCF = PGI - V&BD - OE - DS, where PGI = Potential Gross Income, V&BD = vacancy and bad debt, OE = Operating expenses, DS = debt service BTNR = Selling Price (SP) - Selling expenses (SE) - Mortgage Balance (MB)

Mortgage Equity Technique V = M + E or V = (a)(V) + (NOI1 - DS)/(1+k)1 + (NOI2 - DS)/(1+k)2 + ... + (NOI n - DS)/(1+k)n + (SP - MB)n/(1+k)n Where M = present value of mortgage, E = present value of cash to equity investor, k = investor’s discount that reflects debt in capital structure, and a = loan to value ratio (L/V) To apply this technique we need to find the following: (1) Debt service; (2) BTCF; (3) Mortgage balance (MB); (4) Before tax net reversion (BTNR)

Application of mortgage-equity technique Assumptions: NOI for year 1 = $338,000; growth rate of NOI = 2.5%; property appreciation rate = 2.5%, holding period = 5 years; discount rate = 14%, mortgage interest rate = 11%, term (m) = 20 years (240 months); loan to value ratio = 70% (1) Debt Service (DS) = (MC i %/12, m )(12) (a)(V) = (MC 11%/12, 240)(12) (.7)(V) = (.010322)(12) (.7)(V) = .086705V PV of DS = (.086705V)(PVAF 14%/12, 5 years) = (.086705V)(3.433081) = .297665V (2) PV of NOI = {[1 - (1+g)n/(1+r)n]/(r- g)}x NOI1 = {[1 - (1.025)5/(1.14)5]/(.14 - .025)}x $338,000 = (3.585930678)(338000) = $1,212,044

Mortgage-Equity Technique Mortgage Balance (MB) = (a)(V)(PO i%/12, m - t) where PO = Proportion of loan outstanding =( PVAF 11%/12, 180 months)/(PVAF 11%/12, 240 months) = 87.981937/96.881539 = .908139. So at end of holding period mortgage balance is 90.8139% of original mortgage amount and 63.56973% of initial property value MB = (.7)(V)(.908139) = .6356973V PV of MB = .6356973V x PVF (14%, 5 yrs) = (.6356973V x .519369) = .330161V Selling price (SP) = (1+g)n x V = (1.025)5 x V = 1.131408V PV of SP = (1.131408V)(PVF 14%, 5 years) = (1.131408V0)(.519369) = .587618V

Mortgage-Equity Technique V = (a)(V) + PV of NOI - PV of DS + PV of SP - PV of MB V = .7V + 1,212,044 - .297665V + .587618V - .330161V .340208V = 1,212,044 V = $3,562,655