Re Academic Press Private Real Estate Investment_6 ppt

File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page:159/188 Most of academic finance and economics ‘‘assumes away’’ the complication of income taxes. This can frustrate the reader who knows that taxes are a reality and usually affect one’s decisions. In defense of academics, it should be noted that working with U.S. income tax rates is frustrating. The code is a moving target. Working with graduated tax rates requires use of a step function, a rather inconvenient mathematical device. As this chapter deals directly with taxes, we may not assume them away lest the entire subject disappear. However, some assumptions are necessary in the interest of simplicity. One of these is a flat tax rate. The alert reader knows that U.S. income tax rates change with income levels, but our conclusions here will not change by relaxing the flat tax assumption. There are lessons for readers outside the United States. First, Section 1031 has been in the U.S. tax code since its inception. Congress intended citizens have the right to defer tax on gains when transferring from one location to another while remaining in the same business. This fosters important incentives that contribute to the development of society. Second, taxation policy affects behavior. The U.S. tax code in its present form is not a work of art. Even the administration of Section 1031 transfers has become needlessly complicated under the guise of ‘‘simplification.’’ Policymakers in other countries may wish to proceed with caution before following the U.S. model. Recent amendments to Section 1031 have had unintended consequences that influence the market. A primary justification for ignoring income taxes in other writings is that all economic agents operate in a common income tax environment. The marginal difference in tax brackets spanning different ranges of income certainly affects the accuracy of any particular calculation, but these may be viewed as de minimus. The central message of this chapter is that some capital gain taxes may be delayed and some may actually be eliminated. This is a more powerful effect than one of merely assuming all taxpayers are not taxed or taxed at the same rate. Indeed, the point of this chapter is that some taxpayers holding particular assets and transferring them in certain ways may reduce, delay, or eliminate some taxes altogether. Organized around a set of stylized examples, this chapter explores not only the obvious benefits of exchanging, but some of the less obvious disadvantages of a poorly thought-out exchange strategy. We will take the usual approach to determine if the benefits exceed the costs. Given that the investor has entrepreneurial abilities and tendencies, we will look at:  The value of tax deferral three ways: (1) in nominal dollar terms, (2) as a percentage of the capital gains tax due on a normal sale, and (3) as a percentage of the value of the property to be acquired The Tax Deferred Exchange 159 File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 160/188  The effect of tax deferral on risk  The cost of exchanging, not just the hard costs, but implicit costs often overlooked  The alternatives of sale and repurchase, refinance, or simply hold for a longer period Examples in this chapter build on earlier examples. In a complex world it is important to be able to isolate the most important variables on which investment decisions rest. As we move through the exchange strategy, we retain the burdensome minutiae that we labored over in earlier chapters. But as many of those calculations involve nothing new, having mastered them in earlier chapters, we now put them out of view. For instance, real estate is usually financed with self-amortizing financing. There is no reason to have the loan amortization calculation in the forefront of our present discussion. Exchange or no exchange, loans are a fact of life, and their amortization is not mysterious. The same can be said for depreciation, sale proceeds, and capital gain calculations. All of these are computed with fairly simple algebraic equations that need not be at center stage with the more important concept of the tax deferred exchange. VARIABLE DEFINITIONS The examples in this chapter are similar to those in Chapter 4 describing basic investment analysis. 2 For pedagogical reasons we included a number of variables in Chapter 4 that are not needed here. For example, because operational variables prior to net operating income are mathematically trivial, they have been ignored here so that all examples in this chapter begin with net operating income (NOI). The list of variables used in this chapter has considerable overlap with that in Chapter 4 to which we add variables that permit growth rates to be different in different years. lc ¼ logistic constant when using the modified logistic growth function af ¼ acceleration factor when using the modified logistic growth function The electronic files that accompany this chapter provide a fully elaborated set of examples in Excel format. 2 The important difference is that in Chapter 4 value is a function of a market rate of growth. Here value is a function of both income growth and capitalization rate. The effect and importance of this difference is illustrated in the electronic files for this chapter. 160 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 161/188 THE STRUCTURE OF THE EXAMPLES The examples illustrating the ideas in this chapter are organized as follows. 1. The Base Case: Purchase–Hold–Sell. An initial ‘‘base case’’ (base) is examined to provide background and context. In the base case the investor merely purchases, holds for six years, and sells a single property. During the holding period the value grows mono- tonically. 2. Example 1: Modifying the Growth Projection. Example 1 (dataEG1) deviates from the base case only by introducing the idea of growth at different rates over different time periods (the logistic growth idea discussed in Chapter 4) during the six-year holding period. 3. Example 2: The Tax Deferred Exchange Strategy. The second variation from the base case involves two properties (dataEG2a and dataEG2b) that are each held for three years in sequence. The second property is acquired via exchange of the first property. Thus, the ownership of the two properties spans the same time period as Example 1. Each property grows in value under the same conditions as those assumed for dataEG1. 4. The Sale-and-Repurchase Strategy: Tax Deferral as a Risk Modifier. The outcome of the exchange strategy is then contrasted with the results achieved via the taxable sale of the first property (dataEG2a) at the end of year three, the purchase of the second property (dataEG2c) with the after-tax proceeds of the sale of the first, and concluding with the taxable sale of the second property at the end of three more years (again a total of six). 5. The Sale-and-Better-Repurchase Strategy: The Cost of Exchanging. The sale-and-repurchase strategy portion of Example 2 is re-examined (dataEG2a and dataEG2d) using a lower price for the second purchase, presumed to be achieved with superior negotiation following the taxable sale of the first property. This addresses the question of how much price discount is needed upon acquisition of the second property to offset the value of tax deferral if exchanging is not an option. 6. Example 3: Exchanging and ‘‘the Plodder.’’ In the last variation (dataEG3a and dataEG3b) we repeat the same analysis as in Example 2, but return to the monotonic growth of the base case. We then compare the exchange outcome under those conditions with the sale and purchase alternative (dataEG3a and dataEG3c). Finally, we return to the base case assumptions to consider a longer term, 12-year buy-and- hold strategy of a single property. The Tax Deferred Exchange 161 File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 162/188 Each example and variation illustrates a different strength or weakness of holding, selling, exchanging, and/or reacquiring property. THE BASE CASE: PURCHASE–HOLD–SELL Data for our base case project is entered in Table 7-1, followed by the rules of thumb measures in Table 7-2. The final year of the multi-year projection is shown in Table 7-3. For the terminal year reversion, we need calculations TABLE 7-1 Base Case Inputs dp $360,000 i .095 ⁄ 12 noi $119,925 initln $875,000 txrt 0.35 t 360 dprt 1 ⁄ 27.5 r 0.13 land 0.3 k 6 cr o 0.0936 scrt 0.075 g 0.03 cgrt 0.15 lc 0 recaprt 0.25 af 0 ppmt 0 units 22 TABLE 7-2 Rules of Thumb Capitalization rate 0.0971 Price per unit $56,136 Cash-on-cash return 0.0824 Debt coverage ratio 1.36 Loan-to-value ratio 0.7085 TABLE 7-3 Terminal Year Operating Performance Net operating income $139,025.94 Debt service $88,289.70 Depreciation $31,436.40 Income tax $9,785.96 After-tax cash flow $40,950.30 162 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 163/188 made at the time of sale, shown in Table 7-4. The npv and irr results for the base case are shown in Table 7-5. It is important to point out that the IRR in Table 7-5 is the after-tax IRR. Graphically, in Figure 7-1, we see the components of the sale proceeds in the base case. This sets the scene for the primary purpose of this chapter, which is to examine the ramifications of NOT having to pay capital gains tax. The Base Case represents a quite standard discounted cash flow (DCF) analysis with monotonic growth over a fixed holding period terminating in a taxable sale. Next, combining the modified logistic growth function described in Chapter 4 with the exchange strategy, we relax some of these assumptions. EXAMPLE 1—MODIFYING THE GROWTH PROJECTION First, we modify our data to reflect the entrepreneurial growth associated with an early transformation period. Note that in the base case data the variables for the logistic growth curve, lc and af, were zero. In Table 7-6 we see that in TABLE 7-4 Terminal Year Equity Reversion Sale price $1,474,655 Beginning loan balance $875,000 Ending loan balance $833,449 Original cost $1,235,000 Sale costs $110,599 Accumulated depreciation $188,618 Capital gain $317,674 Capital gains tax $66,513 Pre-tax net equity $530,607 After-tax net equity $464,094 TABLE 7-5 Base Case Net Present Value and Internal Rate of Return Base case NPV $557 IRR 0.130351 The Tax Deferred Exchange 163 File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 164/188 Allocation of Sales Proceeds $1,474,654 Loan Balance $833,448 Sale Costs $110,599 Equity Reversion $464,094 CGTax $66,512 FIGURE 7-1 Allocation of final sales proceeds for the base case. TABLE 7-6 Input dataEG1 for Example 1 dp $360,000 i .095 ⁄ 12 noi $119,925 initln $875,000 txrt 0.35 t 360 dprt 1 ⁄ 27.5 r 0.13 land 0.3 k 6 cr o 0.0936 scrt 0.075 g 0.03 cgrt 0.15 lc 1.5 recaprt 0.25 af 2 ppmt 0 units 22 164 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 165/188 dataEG1 these variables take on real values. The first year measures (rules of thumb) for this data are identical to the base case. The difference appears in the ‘‘out’’ years as seen in Table 7-7. There are considerable differences in terminal year outcomes (Table 7-8) arising from the meaningful difference in cash flows over time (Table 7-7) due to the entrepreneurial effort applied. As usual, we are interested in the NPV and IRR measures under these changed conditions (see Table 7-9). They are, understandably, superior to the base case. As the IRR for Example 1 is so much above the required rate of return and the NPV is so large, one might argue that provided the required rate of return, r, was chosen appropriately for a ‘‘normal’’ real estate investment of TABLE 7-7 Six-Year After-Tax Cash Flow Comparison of Base Case with Example 1 Year Base case CF($) EG1 CF ($) 1 29,677 29,677 2 31,828 71,039 3 34,031 74,98 4 36,28 77,34 5 38,59 79,471 6 40,950 81,54 TABLE 7-8 Terminal Year Comparison of Base Case with Example 1 Base ($) Data EG1 ($) Sale price 1,474,655 Sale price 2,074,789 Beginning loan balance 875,000 Beginning loan balance 875,000 Ending loan balance 833,449 Ending loan balance 833,449 Original cost 1,235,000 Original cost 1,235,000 Sale costs 110,599 Sale costs 155,609 Accumulated depreciation 188,618 Accumulated depreciation 188,618 Capital gain 317,674 Capital gain 872,798 Capital gains tax 66,513 Capital gains tax 149,781 Pre-tax net equity 530,607 Pre-tax net equity 1,085,731 After-tax net equity 464,094 After-tax net equity 935,949 The Tax Deferred Exchange 165 File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 166/188 this type—independent of its need for renovation—the excess IRR or the entire NPV represents the return due the investor for his entrepreneurial efforts. Be that as it may, just changing the way value increases has considerably increased the productivity of this investment (and the productivity of the investor’s time). In Figure 7-2 we see that the total outcome and relative size of the components are, as expected, considerably different. Note that in both cases, at the time of sale meaningful investor capital goes to the government in the form of capital gains tax. There are two points to be made here. One, the obvious, is that an investor has a greater incentive to defer taxes the larger the tax liability he faces. More importantly, if one accepts the proposition that the excess IRR or the positive NPV represents a return on his time, the act of deferring the tax on that portion of the gain represents an act of deferring taxes on compensation for the investor’s efforts. The benefit is analogous to that offered employees via corporate retirement and 401(k) plans. But in this case, the outcome is more directly influenced by the investor’s entrepreneurial management style. In the long run, this homegrown TABLE 7-9 Base Case and Example 1 IRR and NPV Comparisons Base NPV $557 DataEG1 NPV $353,158 Base IRR 0.130351 DataEGI IRR 0.298681 Allocation of Sales Proceeds $2,074,788 (b) Loan Balance $833,448 Sale Costs $155,609 CG Tax $149,781 Equity Reversion $935,949 Allocation of Sales Proceeds $1,474,654 (a) Loan Balance $833,448 Sale Costs $110,599 CG Tax $66,512 Equity Reversion $464,094 FIGURE 7-2 Allocation of sales proceeds for base case and Example 1. 166 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 167/188 deferred compensation plan amounts to a pre-tax conversion of human capital into non-human capital. EXAMPLE 2—THE TAX DEFERRED EXCHANGE STRATEGY To examine this further, we look at the same investment period, six years, during which, rather than hold a single property, we acquire two properties in sequence. Each will be held three years, each require entrepreneurial effort, and each will undergo the early year rapid improvement in value due to those efforts. Thus, the entrepreneurial impact occurs twice, and the tax otherwise due on the gain attributable to entrepreneurial effort associated with the first property will be deferred into the second property. We will keep many of the same assumptions regarding growth rates, income tax rates, expense ratios, and rules of thumb from the base case example. Thus, both properties in this example will be presumed to be acquired on the same economic terms, with the second property differing from the first only in scale. The data for the first property (dataEG2a) shown in Table 7-10 are the same as the data in Example 1, except for the shorter holding period resulting from a terminal year of 3. Hence, the acquisition standards for the first property, as represented by the rules of thumb reflecting first year performance, remain identical to those in Table 7-2. To make the comparison as fair as possible, for the second property we will again replicate the acquisition standards from the first property. That is, we wish the first year rule of thumb ratios in the second property to be the same as those for the first property. The purpose of this is to hold constant a kind of risk standard, the assumption being that two properties with the same loan- to-value (LTV) ratio and debt coverage ratio (DCR) expose the investor to approximately the same risk. While not perfect, this approach is useful in a stylized example such as this for reasons that will become apparent later. To accomplish this we will ‘‘back in’’ to some of the values in the second property in order to hold first year rule of thumb measures constant. One consequence of this is that some of the values may reflect unrealistic odd numbers, which in practice would likely be rounded to the nearest $1,000. The ability to sell a property and defer payment of income taxes is indeed cause to celebrate. But there is a price attached. Any gain not recognized for tax purposes on disposition cannot be included in the tax basis of the newly acquired property and thus is not eligible for depreciation. The practical effect of this is to transfer the basis from the old property to the new, an The Tax Deferred Exchange 167 File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 23.12.2004/4:07pm Page: 168/188 accounting task known as an exchange basis adjustment. The exchange basis adjustment then determines the depreciation deduction available for the second property. Most of the accounting complexity in the exchange basis adjustment arises from partially tax deferred, delayed, or reverse exchanges. In the interest of simplicity, we will assume the exchange is concurrent and fully tax deferred. Qualifying for this is not difficult. One need only acquire a property with at least as much equity and at least as much debt as the property disposed. Stated differently, except as may be necessary to pay transaction costs, one may not take any money out of the transaction (such money, known as ‘‘boot received’’ must be zero) and one must not be relieved of debt when the comparing debt on the new property to debt on the old (net mortgage relief must be zero). EXCHANGE VARIABLE DEFINITIONS Exchange variable definitions, having their primary influence on the exchange basis adjustment, are shown below. New loan ¼ new loan on acquired property Old loan ¼ loan on disposed property at time of disposition Mortgage relief ¼ mortgage relief in the exchange Total boot ¼ total boot received from the transaction Boot paid ¼ total boot paid into the transaction Acquired equity (new equity) ¼ equity in acquired property (forced to be equal to the pre-tax sales proceeds from the prior property) TABLE 7-10 Data Input dataEG2a for Example 2a dp $360,000 i .095 ⁄ 12 noi $119,925 initln $875,000 txrt 0.35 t 360 dprt 1 ⁄ 27.5 r 0.13 land 0.3 k 3 cr o 0.0936 scrt 0.075 g 0.03 cgrt 0.15 lc 1.5 recaprt 0.25 af 2 ppmt 0 units 22 168 Private Real Estate Investment [...]... non-simultaneous exchange But among the different districts of the U.S Tax Court, the authorization was uneven, with some more permissive and some more restrictive In 1986 Congress stepped in and codified procedures that became Treasury regulations in 1991 These procedures are intricate and should be carefully followed by anyone planning an exchange However, there are important general caveats that must not... 1.5 recaprt 0.25 af 2 ppmt 0 units 33 dprt 178 Private Real Estate Investment TABLE 7-20 Exchange vs Sale and Repurchase Exchange Sale and repurchase NPV $1,039,897 $957,920 IRR 0.46205 0.447485 One such advantage is the higher depreciation deduction Table 7-20 shows a comparison of the results under the two strategies Suppose we attempt to replicate the exchange NPV and IRR results in the sale-and-repurchase... 0.00791667 intial loan balance 2321146 total amortization period 360 investor required rate of return 0.13 investor required rate of return 0.13 terminal year 3 terminal year 3 selling cost rate 0.075 selling cost rate 0.075 capital gain rate 0.15 capital gain rate 0.15 recapture rate 0.25 recapture rate 0.25 prepayment penalty 0 prepayment penalty 0 number of units 22 number of units 37 TABLE 7-14 Rules... 0 interest rate 0.00791667 interest rate intial loan balance total amortization period 875000 360 intial loan balance total amortization period 0.00791667 1289670 360 investor required rate of return 0.13 investor required rate of return 0.13 terminal year 6 terminal year 6 selling cost rate 0.075 selling cost rate 0.075 capital gain rate 0.15 capital gain rate 0.15 recapture rate 0.25 recapture rate... rapidly in the early years of ownership There are other, perhaps more numerous, real estate investors who are ‘‘buy-and-hold’’ types They rely on neighborhood or regional growth over time to increase the value of their investments, perhaps offsetting inflation better than financial assets would over the same period of time To illustrate this type of investor, we will return to the inputs from the base case... to be restored to the condition it was prior to the changes No one can predict the destination of this very political matter, and current tax law should be consulted at the time plans are made 174 Private Real Estate Investment calculate those earnings If we assume the IRR from these two properties is the investor’s average return, the nominal dollar value of tax deferral is simply Deferred Tax à ð1þIRRÞholding... property two of $2,898,262, which is $377,870 less than the $3,276,132 value of the exchange-acquired property two (dataEG2b) This $377,870 difference is, therefore, unavailable to grow under the owner’s entrepreneurial direction Our interest is in learning how the absence of this capital affects the return after crediting back certain advantages of the purchase-and-sale strategy TABLE 7-19 Data Input dataEG2c... deferral, pay more for property they acquire via an exchange than they would have if they had merely purchased the property Some investors view the deferral of taxes as ‘‘an interest free loan from the government.’’ This is questionable reasoning in that it assumes that investors have no money of their own, but are merely custodians of the government’s money Regardless, the incentives are aligned to... are the same except for price per unit (because the second property is acquired three years later) and after-tax cash on cash return (because of the reduced depreciation arising from the carryover basis) Important to our discussion later in this chapter, note that two risk variables, loan-to-value ratio and debt coverage ratio, are the same The net effect is that, midway in our investor’s six-year real. .. are less than 100% Recall above that, given a moderate IRR of 15% and a short holding period, the $57,373 value of tax deferral as a percentage of the acquired property from Table 7-16 was a rather modest 1.7513% Suppose that tax deferred exchanges carry additional transaction costs They do in a real sense in that specially qualified brokers, attorneys, tax accountants, and escrow holders are required, . $66 ,512 Equity Reversion $ 464 ,094 FIGURE 7-2 Allocation of sales proceeds for base case and Example 1. 166 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch007.3d Creator:. 2 interest rate 0.0079 166 7 interest rate 0.0079 166 7 initial loan balance 875000 intial loan balance 23211 46 total amortization period 360 total amortization period 360 investor required rate of return. loan $2,321,1 46 Mortgage relief 0 Net mortgage relief 0 Equity acquired $954,9 86 Value acquired $3,2 76, 132 Indicated gain $67 1,448 Recognized gain 0 New adjusted cost basis $2 ,60 4 ,68 3 New land