Fundamentals of Real Estate Lecture 5 Spring, 2002 Copyright © Joseph A. Petry

2 Example: Case Problem #2 – You are considering the purchase of a quadruplex apartment. Effective gross income during the first year of operations is expected to be $33,600 ($700 per month per unit). First year operating expenses are expected to be $13,440 (at 40% of EGI). The purchase price is $200,000, financed with $60,000 equity and a loan of $140,000, standard fixed rate mortgage of 30 years at 8% interest. Assume annual payments and no up-front financing costs. Investment Property Analysis

3 Example: Case Problem #2 a) What is the overall capitalization rate? b) What is the (effective) gross income multiplier? c) What is the equity dividend rate? d) What is the debt service coverage ratio? e) Assume the requires a minimum debt coverage ratio of 1.2. What is the largest loan that you could obtain if you decided that you wanted to borrow more than $140,000? Investment Property Analysis

4 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 depreciation rights of the property – 1& 2 not depreciable, 3 & 4 depreciable Federal Income Taxation--Ch 4

5 Investment properties considered “trade or business property” NOT investment This is favorable to real estate owners, as the principal difference between “trade or business property” and “investment property” is the full deductibility of potential depreciation losses on the sale of a property in the year in which it is sold (provided it has been held for at least one year). Only partial deductibility is permitted on investment property. Federal Income Taxation

6 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

7 Types of Income Passive Activity/ Passive Activity Loss (PAL) rules – 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

8 Types of Income—PAL (cont’d) – 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). – You can use losses to protect other real estate rental income that is generating taxable income. Federal Income Taxation

9 Types of Income—PAL (cont’d) – 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

10 Generalized Income Tax Calculations Federal Income Taxation

11 Federal Income Taxation

12 Federal Income Taxation