Real Estate Taxation

Objectives
Understand the various tax classifications and
exemptions imposed on real estate
Examine the methods of calculating
depreciation and their impacts on taxation
Look at affordable housing programs and the
Low Income Housing Tax Credit (LIHTC)


2
Federal Income Taxation
If RE investors are successful, federal (and usually
state) government shares in that success
If investors lose, federal government may share in
losses
In any event, taxes have a significant effect on
returns that can ultimately be consumed or
invested by investor/taxpayer
Result?
Market values/prices significantly affected by tax law.

3
Taxation of Individuals & Corporations
The double taxation of income renders C
corporations a less desirable form of
ownership than flow-through entities such
as LLCs and LPs.
We therefore focus on the taxation of
individuals who investment in RE via flow-
through entities

4
Tax Classifications for
Real Estate
What are IRS classifications of real estate
holdings?
RE held as personal residence
RE held for sale to others (dealer property)
RE held for use in trade/business (section 1231
assets)
RE held for investment
5
Tax Classifications
Are important because they
Determine if depreciation is allowed
Personal residences and dealer property cant be
depreciated
May affect taxes due on sale
Net gains from sale of trade or business property (held
for at least a year) are taxed a capital gain tax rates
Net losses on trade of business property are deductible
w/o limit against ordinary income

6
Tax Classifications
Investment property
Losses on sales of investment assets are generally
limited
Generally cant be depreciated
Is rental real estate investment property or
trade or business (Section 1231) property?
7
Income Subject to Taxation
8
+ Salary Income
+ Consulting Income
+ Sales
Commissions
= Net Active
Income


+ Interest
+ Dividends
+ Annuities
+ Cap Gains on
Stocks
- Interest incurred in
Producing Income
= Net Portfolio
Income
+ Taxable Income from
Business in which no
Material Participation
+ Any Rental Income
- Any Expenses from
Producing Rental
Income
= Net Passive Income

Active Basket Portfolio Basket Passive Basket
Taxed at ordinary
rates
Taxed at ordinary or
capital gain rates
Ordinary, capital gain,
and/or recapture rates
Passive Activity
Loss Restrictions
Income and losses on all passive activities are first
netted
If net passive income is negative, it cannot be
used to offset active or portfolio income
Passive losses not used are carried forward until
taxpayer has sufficient passive income to deduct
deferred losses.
To use losses from one passive investment,
taxpayer needs other passive activities that are
producing positive taxable income.

9
Important Exemptions
The $25,000 exemption for taxpayers with AGI <
$100,000.
Corporations not subject to PAL restrictions.
If taxpayers primary business is real estate (at
least 750 hours per year), net tax losses from R.E.
rental activities may be used to offset income
from providing the following real estate services.
Examples: Development, Construction, Acquisition,
Management, Brokerage, Leasing

10
Tax Rates on Individuals
Exhibit 20-1 Single Taxpayers: Ordinary Income Tax Rate Schedule, 2009
If Taxable Income Is
Over But Not Over
Your Tax
Liability Is
Of the
Amount Over
$0 $8,350 10% $0
8,350 33,950 $835 + 15% 8,350
33,950 82,250 4,675 + 25% 33,950
82,250 171,550 16,750 + 28% 82,250
171,550 372,950 41,754 + 33% 171,550
372,950 108,216 + 35% 372,950
Note: To find updated tax rate schedules, visit the IRS website at www.irs.ustreas.gov
11
Source: Ling & Archer, 3
rd
ed., pg. 528
Tax Rates on Individuals
Exhibit 20-2 Married Taxpayers: Ordinary Income Tax Rate Schedule, 2009
If Taxable Income Is
Over But Not Over
Your Tax
Liability Is
Of the
Amount Over
$0 $16,700 10% $0
16,700 67,900 $1,670 + 15% 16,700
67,900 137,050 9,350 + 25% 67,900
137,050 208,850 26,637 + 28% 137,050
208,850 372,950 46,741 + 33% 208,850
372,950 100,894 + 35% 372,950
Note: To find updated tax rate schedules, visit the IRS website at www.irs.ustreas.gov
12
Source: Ling & Archer, 3
rd
ed., pg. 529
Exempting Tax Liabilities from Operations:
Investors are concerned with cash flows, but tax calculations
are required to get to the net cash flows received by investor
Tax Liability from Operations vs. After-Tax Cash Flow
Tax Calculations Cash Calculations
Economic Net Operating Income (NOI) Economic Net Operating Income (NOI)
+ Capital Expenditures (CAPX)
Depreciation (DEP)
Interest Expense (INT) Interest Expense (INT)
Amortized Financing Costs (AFC) Principal Amortization (PA)
= Taxable Income (TI) = Before-Tax Cash Flow (BTCF)
X Tax Rate (TR) Tax Liability (TAX)
= Tax Liability (TAX) = After-Tax Cash Flow (ATCF)
13
Exhibit 20-3
Source: Ling & Archer, 3
rd
ed., pg. 531
Cost of Mortgage Financing
Mortgage interest is generally deductible in
the year in which it is paid
Repayment of loan principal is not
Up-front financing costs on trade or business
properties or investment properties are
amortized over life of loan
If loan is prepaid before up-front costs are fully
deducted, remaining cost can be deducted in year
of sale

14
Calculating Tax Depreciation
What determines amount of tax depreciation?
Original depreciable basis
Cost recovery period
Method of depreciation

15
Depreciable Basis of
Existing Property
Starting point is original cost basis, which is
equal to total acquisition price of property:
Land, building, and personal property
Original depreciable basis for existing
property:
Original cost basis - land value
Depreciable basis of the real property:
Original depreciable basis minus value of personal
property

16
Cost Recovery Periods
Cost recovery periods for real (not personal)
property:
27.5 years for "residential" income property
39.0 years for "non-residential" income property
(31.5 if placed in service before May 13, 1993)
Distinction between residential and non-
residential income property?

17
Methods of Depreciation
Straight-line method


For 27.5 year residential:
18
period ery re
rate line Straight
cov
1
=
% 636 . 3 , 03636 . 0
5 . 27
1
or rate line Straight = =
Methods of Depreciation
Declining balance methods (i.e. accelerated)



For 175% declining balance and 15 year
recovery period
19
period ery re
x factor rate d Accelerate
cov
1
% =
1
150 1 50 0 10
15
declining rate % . .
| |
= =
|
\ .
Depreciation of
Personal Property
Cost recovery periods for personal (not real)
property:
Carpeting and draperies: 3 years , 200% declining
balance.
Office equipment and fixtures: 7 years, 200%
declining balance.
Landscaping and sidewalks: 15 years, 150%
declining balance

20
Depreciation of
Personal Property
Favorable treatment creates incentive to allocate
as much of depreciable basis to personal
property as possible
Assuming an 8% discount rate, 35% ordinary tax
rate, for every $1M of basis classified as
commercial (39 yr) property, the PV benefit is:
$181K if reclassified as 5-year PP
$165K if reclassified as 7-year PP
$100K if reclassified as 15-year PP
What is cost segregation?
21
Other Taxing Issues
Operating expenses vs. capital expenditures
Substantial improvements
Capital expenditures made after initial purchase
are treated as a separate building or improvement

22
Example: Center Point Office Building
Assumptions contained
80% of $885,000 purchase price (original cost basis), or
$708,000, is allocated to depreciable real property
20% allocated to land (i.e., no personal property)
Investor in 30% tax bracket
Contract rents: 6 suites at $1,800/month and 3 at $1,400/month
Annual market rent increases 3% per year
Vacancy & collection losses: 10% per year
Operating expenses: 40% of EGI each year
CAPX: 5% of EGI each year
Up-front financing cost of $19,912.5 ($663,750 x 0.03) are
amortized over loan term (30 years)

23
Example: Center Point Office Building
Assumptions contained (continued)
Expected holding period: 5 years
Expected selling price in year 5: Year 6 NOI capitalized
at 10%
Selling expenses in year 5$58,300
First mortgage loan: $663,750 (75% LTV)
Annual interest rate: 8%
Up-front financing costs: 3% of loan amount
Capital gain tax rate: 15%
Depreciation recapture tax rate: 25%

24
Office Building:
Taxes From Operations
Assuming, for simplicity, that CAPX are added to tax basis but
not depreciated

Exhibit 22-5
Expected Taxes From Operations
1 2 3 4 5
Net Operating Income (NOI) $89,100 $91,773 $94,526 $97,362 $100,283
+ Capital Expenditures (CAPX) 8,100 8,343 8,593 8,851 9,117
- Interest (INT) 52,900 52,439 51,941 51,401 50,817
- Depreciation (DEP) 18,154 18,154 18,154 18,154 18,154
- Amortized Financing Costs (AFC) 664 664 664 664 17,258*
= Taxable Income (TI) 25,483 28,859 32,361 35,994 23,171
x Ordinary Tax Rate (TR) 0.30 0.30 0.30 0.30 0.30
= Tax Liability (TAX) 7,645 8,658 9,708 10,798 6,951

* Unamortized up-front financing costs = $19,912 4($663.73) = $17,258

25
Source: Ling & Archer, 3
rd
ed., pg. 538
Office Building
Exhibit 22-6
Centre Point Office Building:
Expected After-Tax Cash Flow From Operations
1 2 3 4 5

Net Operating Income (NOI)
89,100 91,773 94,526 97,362 100,283
-
Debt Service (DS)
58,444 58,444 58,444 58,444 58,444
=
Before-Tax Cash Flow (BTCF)
$30,656 $33,329 $36,082 $38,918 $41,838*
-
Tax Liability (TAX)
7,645 8,658 9,708 10,798 6,951
=
After-Tax Cash Flow (ATCF)
23,011 24,671 26,374 28,119 34,887

*adding discrepancy due to rounding

26
Source: Ling & Archer, 3
rd
ed., pg. 538
Estimating Tax Liabilities from Sale
Fully taxable transactions
When seller receives full payment in year of sale
Tax-deferred transactions
Installment sales
Section 1031 like-kind exchanges

27
Fully Taxable Sale
Calculating Cash Flow from Sale
Selling Price (SP)
Selling Expenses (SE)
= Net Sale Proceeds
Remaining Mortgage Balance (RMB)
= Before-Tax Equity Reversion (BTER)
Taxes Due on Sale (TDS)
= After-Tax Equity Reversion
Calculating Taxes
Due on Sale
Net Sale Proceeds
Adjusted Basis (AB)
= Total Gain/Loss (TG)
X Tax Rate
= Taxes Due on Sale
28
IMPORTANT!!
Total gain/loss (TG) is NOT equal to BTER!!!
Source: Ling & Archer, 2
nd
ed., pg. 532& 533
Types of Income Generated
by a Sale
All taxable income from property sales must
eventually be classified as either:
Ordinary income
35% maximum rate
Capital gain income
15% maximum rate
Depreciation recapture income
25% maximum rate

29
Good News and Bad News
at Sale of Investment Real Estate
30
0 1 2 3 4 5 6 7 8 9 10 Year
Acquisition
Cost
Net Sale
Price
Depreciated Value
Acquisition Cost:
Price plus other
acquisition expenses
Net Sale Price: Price
less expenses of sale
Appreciation
Taxed unfavorably
Taxed favorably
Total Depreciation Claimed
Long-term Capital Gain
Tax Rates on Income from Sale
Tax Rates on Ordinary and Capital Gain Income, and Cumulative Depreciation
when Depreciable Real Estate is Sold
Ordinary Rates (TR) 10% 15% 25% 28% 33% 35%
Rates on gain from sale if held less than 12
months
10% 15% 25% 28% 33% 35%
Rates on regular capital gain income
(properties held at lease 12 months)
10% 10% 15% 15% 15% 15%
Rates applied to accumulated depreciation
portion of capital gain
10% 15% 25% 25% 25% 25%
31
Source: Ling & Archer, 3
rd
ed., pg. 543
Adjusted Basis:
CENTER POINT ADJUSTED BASIS (AB)
Cost of Land $ 177,000
+ Cost of Building 708,000
+ Acquisition Expenses 0
= Original Cost Basis (OB) 885,000
+ Additional Capital Expenditures (CAPX) 43,004
- Depreciation Recapture (DEPR) 90,769
= Adjusted Basis (AB) $ 837,235
32
Source: Ling & Archer, 3
rd
ed., pg. 545
Taxes Due On Sale:
CENTER POINT TAXES DUE ON SALE
Net Sales Proceeds (NSP) $ 974,700
- Adjusted Basis (AB) 837,235
= Taxable Gain (TG) 137,465
- Depreciation Recapture (DEPR) 90,769
= Capital Gain (CG) 43,004
Capital Gain Tax (CGTAX) (@15%) 7,004
+ Depreciation Tax (DEPRTAX) (@25%) 22,692
= Taxes Due on Sale (TDS) $ 29,697*
*Adding discrepancy due to rounding.
33
Source: Ling & Archer, 3
rd
ed., pg. 545
After-Tax Equity Reversion:
CENTER POINT: ESTIMATED CASH FLOW FROM SALE
Net Sales Proceeds (NSP) $ 974,700
- Remaining Mortgage Balance (RMB) 631,026
= Before-Tax Equity Reversion (BTER) 343,674
- Taxes Due on Sale (TDS) 29,697
= After-Tax Equity Reversion (ATER) $ 313,977
34
Source: Ling & Archer, 3
rd
ed., pg. 546
Comparison of Three Scenarios
Conclusions:
Leverage increased equity yield
Each dollar of debt earned 8%, but produced 12.2% for equity investor
Income taxes favor real estate investment over other types
Depreciation deductions defer taxes until sale
Capital gain tax rates at sale reduce tax on returns
Effect of Debt & Taxes on IRRs
Center Point Office Building Example
IRR
Unlevered, before tax 12.2%
Unlevered, after tax 9.02%
Levered, before tax 20.3%
Levered, after tax 15.5%
35
Source: Ling & Archer, 3
rd
ed., pg. 548
Components of
Taxable Gain on Sale
36
Exhibit 21-18
Source: Ling & Archer, 2
nd
ed., pg. 538
Effective Tax Rate
Going-in IRR:
Property (Unlevered) Equity (Levered)
Before-tax 12.20% 20.30%
After-tax 9.02% 15.50%
AT/BT 9.02/12.20 = 74% 15.50/20.30 = 76%
Effective Tax Rate 100% 74% = 26% 100% 76% = 24%
37
LOW INCOME HOUSING
TAX CREDITS
38
What is Affordable Housing?
HUD Definition:
Pay no more than 30% of adjust gross income for
housing.

Eligibility for programs starts at 80% Area
Median Income, but deeper targeting typically
applies

39
What is Affordable Housing?
National Median Income (2008): $50,303

80% AMI = $40,242
60% AMI = $30,182
50% AMI = $25,152
30% AMI = $15,091*

*$7.55/hr working 40 hrs/week
40
What is Affordable Housing?
Two ways to make housing affordable:

Provide rental assistance to resident

Provide special financing
Decrease propertys debt burden
Lower debt results in lower required NOI
Lower NOI allows for lower rents

41
Why Develop Affordable Housing?
High Developer Fees
10-15% vs. 3-5% in conventional deals

Low Operating Risk
Strong demand in most markets

Low Default Risk
Low leverage, high reserves

No or low Developer Equity Requirement

42
History of Programs
Federal Home Loan Bank

HUD Multi-family Development

Section 8 Rental Assistance Program

USDA Rural Development

HOPE VI

Low Income Housing Tax Credit

43
Low Income Housing Tax Credit
Federal tax credit (not deduction) to facilitate the
development of affordable multi-family rental
housing

The tax credit is realized each year for 10 years

Governed by the IRS tax code (Section 42), but
administered at a state level

Currently, $1.75 tax credit per state capita

44
Low Income Housing Tax Credit
Types of LIHTC
9% for new construction
4% for acquisition

Financed the development of 1 million units over
past 10 years
40% of all multi-family rental during that time

Annual foreclosure rate of 0.01% vs. 1-3% for
other commercial properties

45
Low Income Housing Tax Credit
LIHTC is purchased by an investor limited
partner who provides equity capital

Investor achieves their return through the tax
credit and depreciation tax losses (not
property income generation)

LIHTC can provide 50% to 80% of Total
Development Costs

46
Example: Low Income Housing Tax Credit
Calculation
Federal LIHTC Calculation
Total Eligible Basis
1
$8,000,000
LIHTC
2
x 8.00%
% Low Income Units x 100.00%
Total Annual Credit = $640,000
10 year credit
3
x10 = $6,400,000
LIHTC Equity Investor %
4
x 99.99%
LIHTC Price
5
x $0.90
Total Federal LIHTC = $5,759,424
1
Costs are included in Eligible Basis if they are capitalizable, typically all cost less land & reserves.
2
This rate is set on a monthly basis and is calculated based on the Applicable Federal Rate (AFR).
3
The Low Income Housing Tax Credit is realized over a 10 year period.

4
The LIHTC Equity investor owns 99.99% of the development, and thus received 99.99% of the tax benefits.

5
This is the price paid for each dollar of LIHTC and can range from $0.75 to $1.05 based on market.

47
Other Resources Available for Low-Income
Housing Projects
State Tax Credit
Historic Preservation Tax Credit
Federal HOME loan
Community Development Block Grant
Federal Home Loan Bank
City Funds
48
CASE STUDY 1 PART C: REAL ESTATE INVESTMENT
ANALYSIS FOR A STABILIZED LEVERED PROPERTY
INCLUDING TAXES
49
Sources
US Census Bureau (September 2009). Current population reports: consumer
income. Retrieved October 14, 2009 from
http://www.census.gov/prod/2009pubs/p60-236.pdf
Ling, D. & Archer, W. (2008). Real estate principles: a value approach (2nd
ed). New York: McGraw-Hill/Irwin.
Contact: The McGraw Hill Companies, Inc.
1221 Avenue of the Americas
New York, NY 10020
Ling, D. & Archer, W. (2010). Real estate principles: a value approach (3rd
ed). New York: McGraw-Hill/Irwin.
Contact: The McGraw Hill Companies, Inc.
1221 Avenue of the Americas
New York, NY 10020
US Department of Housing and Urban Development. (2009). Retrieved
October 14, 2009 from http://www.hud.gov/
US Dept. of Agriculture: Rural Development (2009). Retrieved October 20,
2009 from http://www.rurdev.usda.gov/rd/aboutrd.html




50