Myers, Sean 7/8/2014

For Educational Use Only

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

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

Real Estate Investor's Deskbook
Database updated May 2014
Alvin Arnold
Chapter 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 taxable
gain, all of the cash flow from the property itself is received tax free, and the tax loss itself may be used to offset other income
of the investor and the tax savings thereby achieved is added to the cash flow from the investment itself.
TABLE 2.4 Apartment Building Investment
A. Investment Terms
Purchase price
First mortgage loan (10 percent interest; 11.6 percent constant; twenty
years)
Second mortgage loan (14 percent interest; no amortization)
Cash down
B. First-Year Cash Flow Statement
Gross income
Vacancy8 percent
Effective gross income
Operating expenses
Net operating income
Debt service:
First mortgage
Second mortgage
Less: total debt payments
Cash flow
C. First-Year Tax (Profit-and-Loss) Statement
Net operating income
Interest on first mortgage
Interest on second mortgage
Less total interest
Net income after interest
Depreciation (on $1,000,000 building cost) (3.64 percent)
Taxable profit (loss)
Or Another Way to Derive Taxable Profit (Loss)
C. First-Year Tax Statement
Cash flow
Add back:
First mortgage amortization
Total
Deduct:
Depreciation
Taxable profit (loss)

$1,200,000
$650,000
150,000
400,000
$210,000
16,800
$193,200
84,000
$109,200
$75,400
21,000
96,400
$12,800
$109,200
$65,000
21,000

2014 Thomson Reuters. No claim to original U.S. Government Works.

86,000
$23,200
36,400
$(13,200)

$12,800
10,400
23,200
36,400
$(13,200)

Myers, Sean 7/8/2014

For Educational Use Only

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

In the example given here, the investor receives a positive cash flow in the first year of $12,800 and, in addition, generates
a tax loss of $13,200. Assuming the investor is in the 36% bracket, the loss gives him an additional benefit of $4,752. (We
assume 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 investment
of $400,000. This unusually low returnone normally not acceptable to an investoris necessary in this example in order
to 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 forth
the manner in which the total purchase price is paid. In this example, the investor puts one-third cash down and raises the
balance of the price with two mortgages. The first mortgage, at 10% interest and with annual debt service equal to 11.6% of
the total loan, will fully amortize (be paid off) in 20 years. Because we assume a fixed-rate loan, it is likely that the lender
will 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 to
be 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 arranging
new financing at that time. The purchaser assumes that increased cash flow from the property will permit him to refinance
both the first and second mortgages at that time into a single mortgage. However, this is far from being assured and represents
one 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 a
cash 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 amortization
is not a tax deduction, only the interest payments on the two mortgages may be deducted for tax purposes. (The difference
between the total interest deductions in Section C and the debt service in Section B is $10,400, which is the amortization on
the 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 (which
is not depreciable). Since depreciation is a noncash outlay, no depreciation deduction is shown in Section B, where cash flow
was 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 tax
law, the investor may deduct $36,400 on his tax return. He simultaneously reduces his tax basis in the property by the same
amount (see 7:9 to 7:33). The combined deductions for interest and depreciation results in a tax loss of $13,200, which
represents 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 cash
flow 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).
Westlaw. 2014 Thomson Reuters. No Claim to Orig. U.S. Govt. Works.
End of Document

2014 Thomson Reuters. No claim to original U.S. Government Works.

2014 Thomson Reuters. No claim to original U.S. Government Works.