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An in-depth analysis of the tax consequences of selling real estate investments, including calculating tax consequences, passive activity loss restrictions, and after-tax investment analysis. Topics covered include capital gains tax rates, depreciation recapture, and the effect of suspended losses. The document also discusses tax wrinkles such as installment sales and tax-deferred exchanges.
Typology: Exercises
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Taxation of Real Estate Investments II
a) Calculating Tax Consequences from the Sale Example: Continue the example from before: $2.5 million purchase price 75% LTV mortgage over 25 years at 8.5 percent interest with 2 points 4.5-year holding period
Suppose we sell the property at an 8 percent cap rate and that the costs of sale will be 5 percent of the sale price.
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Three different rates may apply at the time of the sale:
The ordinary income tax rate is used to credit any unamortized loan fees at the time of the sale.
The depreciation recapture rate (currently 25 percent) applies to the straight line depreciation that was claimed on the property during the holding period.
This is limited to the amount of the entire gain.
The long-term capital gains tax rate (currently 15 percent in most circumstances) applies to gains that result purely from appreciation of the property (the total gain less straight-line depreciation).
Note that if the entire gain is due to depreciation recapture, none of the gain is taxed at this rate.
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We calculated the annual operating cast flows before:
Year Cash Flow 1 31, 2 64, 3 64, 4 63, 5 61,
The cash from the sale of the property is:
Sale price
Thus, the total cash flows for this property are:
Year Cash Flow 0 (662,500) 1 31, 2 64, 3 64, 4 63, 5 61,294 + 1,064,336 = 1,125,
The NPV of this investment (@ 15 percent) is __________.
The IRR of this investment is __________.
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a) Installment Sales Suppose you were to sell the property but carry a note for the buyer. In this case, you might end up with a capital gains tax liability that exceeds any up-front cash you actually receive.
The tax code allows you to recognize your gain at the time you actually receive payments, rather than when the transaction closes, thus avoiding this problem.
Realized gain is the actual capital gain on the property.
Recognized gain is the gain on which the investor will be taxed.
b) Tax-deferred (1031) Exchanges At times an investor would like to remain invested in real estate, but alter the specific investment.
Tax-deferred exchanges allow you to do this without paying capital gains taxes on the transaction.
Advantages:
Disadvantages:
