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

2. 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

3. 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

4. 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

5. 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

6. 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)(.5)
= $15,000.
Useable Passive loss = $10,000 (25,000-15,000)

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

8. Application of PALL
ATCF assuming no other PIG

9. 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.

10. Application of PALL
Using Accumulated Loss to reduce capital gain

11. 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

12. 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.

13. 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

14. 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

15. 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 He spends $2 million to restore it and places the rehabilitated building in service in January 1988

16. 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, $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?

17. 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 %
second year %
third year %
fourth year %
fifth year %

18. 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%

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

20. 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
TI $37, $42, $45,692
GROSS TAX DUE , , ,793
LESS CREDIT ,
NET TAX DUE $ $11, $12,793

21. Analysis of investment tax credit
After tax cash flow with investment tax credit
BTCF $60, $65, $70,000
NET TAX DUE , ,793
ATCFw/ITC $59, $53, $57,207
After tax cash flow if ITC is not taken
BTCF $60, $65, $70,000
TAX DUE , , ,722
ATCFwo/ITC $49, $53, $57,278

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

23. 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

24. 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

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

26. 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

27. 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

28. 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

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

30. 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

31. 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

32. 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?

33. 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

34. 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)

35. 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, $3,500, $3,350, $3,200,000
NOI $346, $390, $325, $310,250
Cap rate % % % %
Suggested cap rate = 10.42%
Estimated NOI of subject property = $338,000
Market value of subject property = $338,000/ = $3,243,762

36. 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)( x12) + (.3)(.085) = or 11.22%
Estimated market value = $338,000/ = $3,012,477

37. Further Analysis using Band of Investments Technique
Indicated Mortgage Amount = (.7)(3,012,477) = $2,108,734
Debt Service = $2,108,734 x 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/ = 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

38. 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) 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

39. 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/( ) = $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

40. 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]/( )}x $338,000 + [(1.025)5 x V]/(1.13)n
V = x $338, V
V = 1,242,285 ; V = $3,219,047 (compare with previous page answer)

41. 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)

42. Mortgage Equity Technique
V = M + E or
V = (a)(V) + (NOI1 - DS)/(1+k)1 + (NOI2 - DS)/(1+k) (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)

43. 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)
= ( )(12) (.7)(V) = V
PV of DS = ( V)(PVAF 14%/12, 5 years) = ( V)( ) = V
(2) PV of NOI = {[1 - (1+g)n/(1+r)n]/(r- g)}x NOI = {[1 - (1.025)5/(1.14)5]/( )}x $338,000
= ( )(338000) = $1,212,044

44. 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) = / = So at end of holding period mortgage balance is % of original mortgage amount and % of initial property value
MB = (.7)(V)( ) = V
PV of MB = V x PVF (14%, 5 yrs) = ( V x ) = V
Selling price (SP) = (1+g)n x V = (1.025)5 x V = V
PV of SP = ( V)(PVF 14%, 5 years) = ( V0)( ) = V

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