CHAPTER 11

Investment Analysis and Taxation of Income Properties

TRUE/FALSE

1. Debt coverage ratio measures the degree to which the NOI from the property is expected to
exceed the mortgage payment. (T)

2. CPI adjustments shift the risk of unexpected inflation is shifted to the lessor. (F)

3. Expense stops shift the risk of increases in expenses to the lessee while allowing the lessor
to retain the benefit of any decrease in expenses. (T)

4. In making an investment decision, IRR analysis will lead to a different “go/no-go” decision
than NPV analysis. (F)

5. The equity dividend rate is an accurate measure of investment yield because it takes into
account future cash flows. (F)

6. The use of a CPI index in lease contracts shifts risk to the tenant. (T)

7. Expense stops protect the lessee from unexpected changes in market rents. (F)

8. A gross lease is riskier for the lessor than a net lease. (T)

9. The debt coverage ratio is used by lenders to indicate the riskiness of a loan. (T)

10. When calculating the adjusted IRR the cash flows are always discounted to a present value
at a safe rate. (F)

11. Property held as a personal residence cannot be depreciated. (T)

12. Residential property is depreciated over 27.5 years where as non-residential property is
depreciated over 31.5 years. (T)

13. The deductibility of depreciation to calculate taxable income will usually cause the effective
tax rate to be lower than the actual tax rate. (T)

14. When the sale of a passive activity produces a capital loss and unused passive losses from
previous years remain, the unused losses can be used to offset any other source of income.
(T)

15. If an individual actively participates in the management of a rental property, he may deduct
the full amount of the passive activity losses from active income, regardless of his adjusted
gross income. (F)

MULTIPLE CHOICE

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16. Which of the following is NOT one of the primary benefits of investing in real estate income
property? (E)

(A) Net Income—Dollars left over after collecting rent and paying expenses but before
considering taxes and financing costs
(B) Property Sale—Expecting a price increase over a specified holding period increases
investor return
(C) Diversification—Reducing overall risk to hold many types of investments
(D) Taxes—Preferential tax benefits mean taxable income is often less than before-tax cash
flow
(E) Business cycles—Real estate income properties tend to generate higher incomes when
other investments are in decline

17. Which of the following statements regarding equity is TRUE? (A)

(A) The amount of equity an investor has in a property may change over time if the property
value and loan balance changes
(B) The amount of equity an investor has in a property depends on the value of the equity
the investor has in his or her other investments
(C) The outstanding balance on loan on the property does not affect the amount of equity an
investor has in the property
(D) All of the above

18. An effective tax rate: (D)

(A) Takes into account the effects of depreciation and time value of money
(B) Measures the actual difference between the BTIRR and the ATIRR
(C) Can be less than the actual marginal tax rate
(D) All of the above

19. The real estate industry: (A)

(A) Is highly competitive

(B) Is a relatively small market
(C) Is relatively concentrated, with a few owners controlling most of the market in most
markets
(D) All of the above
(E) None of the above

20. A restaurant is for sale for $200,000. It is estimated that the restaurant will earn $20,000 a
year for the next 15 years. At the end of 15 years, it is estimated that the restaurant will sell
for $350,000. Which of the following would be MOST LIKELY to occur if the investor’s
required rate of return is 15 percent? (B)

(A) Investor would pursue the project

(B) Investor would not pursue the project
(C) Investor would pursue the project if the holding period were longer than 15 years
(D) Not enough information provided

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21. A property produces a first year NOI of $100,000 which is expected to grow by 2% per year.
If the property is expected to be sold in year 10, what is the expected sale price based on a
terminal capitalization rate of 9.5% applied to the eleventh year NOI? (B)

(A) $1,308,815
(B) $1,283,152
(C) $1,263,158
(D) $1,257,992

22. A property that produces a first year NOI of $80,000 is purchased for $750,000. The NOI is
expected to increase by 15% in the sixth year when some of the leases turnover. The resale
price in year 10 is expected to be $830,000. What is the net present value of the property
based on the 10-year holding period and a discount rate of 9.5%? (D)

(A) $87,433
(B) $87,221
(C) $95,294
(D) $116,490

23. A property is purchase for $15 million. Financing is obtained at a 75% loan-to-value ration
with total annual payments of $1,179,000. The property produces an NOI of $1,400,000.
What is the equity dividend rate (ratio of first year cash flow to equity)? (A)

(A) 5.89%
(B) 9.33%
(C) 7.86%
(D) 8.64%

24. A property that produces a level of NOI of $200,000 per year is expected to be sold in year 5
for $2,000,000. If the property was purchased for $2,000,000, what percent of the IRR can
be attributed to the operating income only? (C)

(A) 10.0%
(B) 90.0%
(C) 37.9%
(D) 63.1%

25. A property that produces an annual NOI of $100,000 was purchased for $1,200,000. Debt
service for the year was $95,000 of which $93,400 was interest and the remainder was
principal. Annual depreciation is $38,095. What is the taxable income? (C)

(A) $5,000
(B) $6,600
(C) - $31,495
(D) - $33,095

26. An investor who has $75,000 in taxable income purchases a building that produces another
$15,000 in taxable income. According to the table below, what is the marginal tax rate? (B)

Taxable Income Marginal Tax Rate

$0 - $34,000 15%

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 $34,001 - $82,150 28%
Over $82,150 31%

(A) 29.50%
(B) 29.57%
(C) 28.00%
(D) 31.00%

27. A small office building is purchased of $1,200,000 with a balloon mortgage that is due at the
end of year 10. Payments are based on a 25 year amortization period. If one point was
charged, what annual amount can be deducted for tax purposes? (A)

(A) $1,200
(B) $480
(C) $0
(D) $800

28. The adjusted basis can be defined as: (A)

(A) Original cost + capital improvements - accumulated depreciation

(B) Sales price - mortgage balance - sales costs
(C) Sales price - accumulated depreciation
(D) Original cost - mortgage balance - sales costs

29. A property is sold for $5,100,000 with selling costs of 3% of the sales price. The mortgage
balance at the time of sale is $3,600,000. The property was purchased 5 years ago for
$4,820,000. Annual depreciation allowances of $153,016 have been taken. If the tax rate is
28%, what is the after-tax cash flow from sale of the property? (D)

(A) $1,184,062
(B) $969,840
(C) $1,347,000
(D) $1,097,218

30. A property produces an after tax internal rate of return of 12.24%. If the investor has a
marginal tax rate of 31%, what is the before-tax equivalent yield? (D)

(A) 8.45%
(B) 11.39%
(C) 16.03%
(D) 17.74%

31. Which of the following includes income from real estate classified as capital assets? (C)

(A) Passive income

(B) Active income
(C) Portfolio income
(D) Passive activity income

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32. Which of the following is FALSE regarding an expense stop? (A)

(A) All operating expenses are covered by the stop

(B) The passthrough is based on the tenant’s percentage of total leasable area
(C) Expenses to be included must be agreed upon and included in the lease
(D) The stop is often based on the actual amount of operating expenses at the time the
lease is signed

33. Which of the following is FALSE regarding expense stops? (C)

(A) Expense stops protect owners against increases in expenses

(B) Expense stops are usually based on expenses during the first term of the lease
(C) Expense stops can pass through expense savings to tenants
(D) Expense stops provide some protection against inflation

34. The minimum lenders typically require for a DCR is: (C)

(A) 0.8
(B) 1.0
(C) 1.2
(D) 1.5

35. Which of the following is FALSE regarding DCR? (B)

(A) It indicates whether NOI is sufficient to cover mortgage payments

(B) It is not of concern to lenders when loan to value ratios are low
(C) It is an indication of risk for the lender
(D) It is derived from NOI / Mortgage Payment

36. Net sale proceeds less adjusted basis of the property determines which of the following? (D)

(A) After-tax net present value of the property

(B) Depreciation allowance for the property
(C) Before-tax net present value of the property
(D) Capital gains or losses

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