Myers, Sean 7/8/2014

For Educational Use Only

§ 2:53.Types of real estate return—Tax benefits—Case..., 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 return—Tax benefits—Case 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
Vacancy—8 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)

1

the investor may deduct $36.4 shows another shorthand way to compute the tax loss. Westlaw. the investor will receive a cash flow of $12. End of Document © 2014 Thomson Reuters. the investor may take a depreciation deduction on the building but not on the land (which is not depreciable). Normally. Table 2.400 (a noncash deduction). (We assume that under an exception to the passive activity loss rules. Then the debt service on the two mortgages is deducted from NOI.800 and. What remains is the cash flow. such a loan will mature in a fairly short time (e. No claim to original U. Government Works.e. his total return (cash flow plus tax savings) is $17. 2 ..4 (First-Year Cash Flow Statement) shows that at the end of the first year.800. Govt. which is then reduced by a vacancy allowance based on the forecast of actual occupancy. This represents gross rental income (assuming 100 percent occupancy). First.5-year recovery period as required by the tax law. © 2014 Thomson Reuters. at a significantly higher interest rate but calling for no amortization during its term. No claim to original U. However.Myers..552. and the purchaser must face the problem of arranging new financing at that time.200. no depreciation deduction is shown in Section B. Section C (First-Year Tax Statement) begins with the same NOI figure as in Section B.000). This unusually low return—one normally not acceptable to an investor—is 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. The first mortgage.. the investor can use the tax loss to offset other income.4% return on the cash investment of $400. will fully amortize (be paid off) in 20 years.4 is divided into three sections (Section C is shown in two different ways).. 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. This figure is developed in two steps. 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 investor receives a positive cash flow in the first year of $12. in addition. In this section. The combined deductions for interest and depreciation results in a tax loss of $13. or dollars available to the investor at the end of the year. Works.200. (See infra §§ 2:62 to 2:67. because loan amortization is not a tax deduction. which represents a tax saving of $4.400 (a nondeductible cash expense) and • Subtract the depreciation of $36. There is no amortization of the second mortgage. No Claim to Orig. However. where cash flow was calculated. The second mortgage loan.S. one taken back by the seller) as an inducement to the buyer to purchase the property. The alternate Section C of Table 2. we begin with the cash flow of $12.400. Sean 7/8/2014 For Educational Use Only § 2:53.752 for an investor in the 36% bracket. which is the amortization on the first mortgage during the year (1.6 percent of $650.Types of real estate return—Tax benefits—Case..) In addition to the interest deduction. Assuming the investor is in the 36% bracket. He simultaneously reduces his tax basis in the property by the same amount (see §§ 7:9 to 7:33).) Section B of Table 2. which represents just under a 4. is likely to be a purchase-money mortgage (i. at 10% interest and with annual debt service equal to 11. and operating expenses.g. we assume that $1 million of the $1. Real Estate Investor's. Since depreciation is a noncash outlay. only the interest payments on the two mortgages may be deducted for tax purposes. In this example. the loss gives him an additional benefit of $4.000. generates a tax loss of $13.. Here.2 million purchase price is allocated to the building and $200.400 on his tax return. (The difference between the total interest deductions in Section C and the debt service in Section B is $10.800 (from Section B) and then do the following: • Add back the first mortgage amortization of $10. © 2014 Thomson Reuters. five years).. U.) Thus.752. In the example given here. Section A (Investment Terms) sets forth the manner in which the total purchase price is paid. Because we assume a fixed-rate loan. the investor puts one-third cash down and raises the balance of the price with two mortgages. Government Works. Applying straight-line depreciation with a 27. NOI is calculated.000 is allocated to the land. this is far from being assured and represents one of the significant risks when utilizing financial leverage in real estate.S.6% of the total loan.S.