Re Academic Press Private Real Estate Investment_6 ppt

Example 1 dataEG1deviates from the base case only by introducing the idea of growth atdifferent rates over different time periods the logistic growth ideadiscussed in Chapter 4 during th

Most of academic finance and economics ‘‘assumes away’’ the complication

of income taxes This can frustrate the reader who knows that taxes are areality and usually affect one’s decisions In defense of academics, it should benoted that working with U.S income tax rates is frustrating The code is amoving target Working with graduated tax rates requires use of a stepfunction, a rather inconvenient mathematical device As this chapter dealsdirectly with taxes, we may not assume them away lest the entire subjectdisappear However, some assumptions are necessary in the interest ofsimplicity One of these is a flat tax rate The alert reader knows that U.S.income tax rates change with income levels, but our conclusions here will notchange by relaxing the flat tax assumption

There are lessons for readers outside the United States First, Section 1031has been in the U.S tax code since its inception Congress intended citizenshave the right to defer tax on gains when transferring from one location toanother while remaining in the same business This fosters importantincentives that contribute to the development of society Second, taxationpolicy affects behavior The U.S tax code in its present form is not a work ofart Even the administration of Section 1031 transfers has become needlesslycomplicated under the guise of ‘‘simplification.’’ Policymakers in othercountries may wish to proceed with caution before following the U.S model.Recent amendments to Section 1031 have had unintended consequences thatinfluence the market

A primary justification for ignoring income taxes in other writings is thatall economic agents operate in a common income tax environment Themarginal difference in tax brackets spanning different ranges of incomecertainly affects the accuracy of any particular calculation, but these may beviewed as de minimus The central message of this chapter is that some capitalgain taxes may be delayed and some may actually be eliminated This is a morepowerful effect than one of merely assuming all taxpayers are not taxed ortaxed at the same rate Indeed, the point of this chapter is that some taxpayersholding particular assets and transferring them in certain ways may reduce,delay, or eliminate some taxes altogether

Organized around a set of stylized examples, this chapter explores not onlythe obvious benefits of exchanging, but some of the less obviousdisadvantages of a poorly thought-out exchange strategy We will take theusual approach to determine if the benefits exceed the costs

Given that the investor has entrepreneurial abilities and tendencies, we willlook at:

The value of tax deferral three ways: (1) in nominal dollar terms, (2) as apercentage of the capital gains tax due on a normal sale, and (3) as apercentage of the value of the property to be acquired

The effect of tax deferral on risk

The cost of exchanging, not just the hard costs, but implicit costs oftenoverlooked

The alternatives of sale and repurchase, refinance, or simply hold for alonger period

Examples in this chapter build on earlier examples In a complex world it

is important to be able to isolate the most important variables on whichinvestment decisions rest As we move through the exchange strategy, weretain the burdensome minutiae that we labored over in earlier chapters But

as many of those calculations involve nothing new, having mastered them inearlier chapters, we now put them out of view For instance, real estate isusually financed with self-amortizing financing There is no reason to have theloan amortization calculation in the forefront of our present discussion.Exchange or no exchange, loans are a fact of life, and their amortization is notmysterious The same can be said for depreciation, sale proceeds, and capitalgain calculations All of these are computed with fairly simple algebraicequations that need not be at center stage with the more important concept ofthe tax deferred exchange

VARIABLE DEFINITIONS

The examples in this chapter are similar to those in Chapter 4 describing basicinvestment analysis.2 For pedagogical reasons we included a number ofvariables in Chapter 4 that are not needed here For example, becauseoperational variables prior to net operating income are mathematically trivial,they have been ignored here so that all examples in this chapter begin withnet operating income (NOI) The list of variables used in this chapter hasconsiderable overlap with that in Chapter 4 to which we add variables thatpermit growth rates to be different in different years

lc ¼ logistic constant when using the modified logistic growthfunction

af ¼ acceleration factor when using the modified logistic growthfunction

The electronic files that accompany this chapter provide a fully elaboratedset of examples in Excel format

2 The important difference is that in Chapter 4 value is a function of a market rate of growth Here value is a function of both income growth and capitalization rate The effect and importance of this difference is illustrated in the electronic files for this chapter.

THE STRUCTURE OF THE EXAMPLES

The examples illustrating the ideas in this chapter are organized as follows

1 The Base Case: Purchase–Hold–Sell An initial ‘‘base case’’ (base)

is examined to provide background and context In the base casethe investor merely purchases, holds for six years, and sells asingle property During the holding period the value grows mono-tonically

2 Example 1: Modifying the Growth Projection Example 1 (dataEG1)deviates from the base case only by introducing the idea of growth atdifferent rates over different time periods (the logistic growth ideadiscussed in Chapter 4) during the six-year holding period

3 Example 2: The Tax Deferred Exchange Strategy The second variationfrom the base case involves two properties (dataEG2a and dataEG2b)that are each held for three years in sequence The second property isacquired via exchange of the first property Thus, the ownership of thetwo properties spans the same time period as Example 1 Each propertygrows in value under the same conditions as those assumed fordataEG1

4 The Sale-and-Repurchase Strategy: Tax Deferral as a Risk Modifier Theoutcome of the exchange strategy is then contrasted with the resultsachieved via the taxable sale of the first property (dataEG2a) at the end

of year three, the purchase of the second property (dataEG2c) with theafter-tax proceeds of the sale of the first, and concluding with thetaxable sale of the second property at the end of three more years (again

a total of six)

5 The Sale-and-Better-Repurchase Strategy: The Cost of Exchanging.The sale-and-repurchase strategy portion of Example 2 is re-examined(dataEG2a and dataEG2d) using a lower price for the secondpurchase, presumed to be achieved with superior negotiationfollowing the taxable sale of the first property This addresses thequestion of how much price discount is needed upon acquisition ofthe second property to offset the value of tax deferral if exchanging isnot an option

6 Example 3: Exchanging and ‘‘the Plodder.’’ In the last variation(dataEG3a and dataEG3b) we repeat the same analysis as in Example 2,but return to the monotonic growth of the base case We then comparethe exchange outcome under those conditions with the sale andpurchase alternative (dataEG3a and dataEG3c) Finally, we return tothe base case assumptions to consider a longer term, 12-year buy-and-hold strategy of a single property

Each example and variation illustrates a different strength or weakness ofholding, selling, exchanging, and/or reacquiring property.

THE BASE CASE: PURCHASE–HOLD–SELL

Data for our base case project is entered in Table 7-1, followed by the rules ofthumb measures in Table 7-2 The final year of the multi-year projection isshown in Table 7-3 For the terminal year reversion, we need calculations

made at the time of sale, shown in Table 7-4 The npv and irr results for thebase case are shown in Table 7-5.

It is important to point out that the IRR in Table 7-5 is the after-tax IRR.Graphically, in Figure 7-1, we see the components of the sale proceeds in thebase case This sets the scene for the primary purpose of this chapter, which is

to examine the ramifications of NOT having to pay capital gains tax.The Base Case represents a quite standard discounted cash flow (DCF)analysis with monotonic growth over a fixed holding period terminating in ataxable sale Next, combining the modified logistic growth function described

in Chapter 4 with the exchange strategy, we relax some of these assumptions

EXAMPLE 1—MODIFYING THE GROWTH

PROJECTION

First, we modify our data to reflect the entrepreneurial growth associated with

an early transformation period Note that in the base case data the variablesfor the logistic growth curve, lc and af, were zero In Table 7-6 we see that in

of Return

Base case

Allocation of Sales Proceeds

$66,512

FIGURE 7-1 Allocation of final sales proceeds for the base case.

dataEG1 these variables take on real values The first year measures (rules ofthumb) for this data are identical to the base case The difference appears inthe ‘‘out’’ years as seen in Table 7-7.

There are considerable differences in terminal year outcomes (Table 7-8)arising from the meaningful difference in cash flows over time (Table 7-7) due

to the entrepreneurial effort applied

As usual, we are interested in the NPV and IRR measures under thesechanged conditions (see Table 7-9) They are, understandably, superior to thebase case

As the IRR for Example 1 is so much above the required rate of returnand the NPV is so large, one might argue that provided the required rate

of return, r, was chosen appropriately for a ‘‘normal’’ real estate investment of

Base Case with Example 1

this type—independent of its need for renovation—the excess IRR or the entireNPV represents the return due the investor for his entrepreneurial efforts Bethat as it may, just changing the way value increases has considerablyincreased the productivity of this investment (and the productivity of theinvestor’s time) In Figure 7-2 we see that the total outcome and relative size

of the components are, as expected, considerably different

Note that in both cases, at the time of sale meaningful investor capital goes

to the government in the form of capital gains tax There are two points to bemade here One, the obvious, is that an investor has a greater incentive todefer taxes the larger the tax liability he faces More importantly, if oneaccepts the proposition that the excess IRR or the positive NPV represents areturn on his time, the act of deferring the tax on that portion of the gainrepresents an act of deferring taxes on compensation for the investor’s efforts Thebenefit is analogous to that offered employees via corporate retirement and401(k) plans But in this case, the outcome is more directly influenced by theinvestor’s entrepreneurial management style In the long run, this homegrown

1 IRR and NPV Comparisons

deferred compensation plan amounts to a pre-tax conversion of human capitalinto non-human capital.

EXAMPLE 2—THE TAX DEFERRED

EXCHANGE STRATEGY

To examine this further, we look at the same investment period, six years,during which, rather than hold a single property, we acquire two properties insequence Each will be held three years, each require entrepreneurial effort,and each will undergo the early year rapid improvement in value due to thoseefforts Thus, the entrepreneurial impact occurs twice, and the tax otherwisedue on the gain attributable to entrepreneurial effort associated with the firstproperty will be deferred into the second property

We will keep many of the same assumptions regarding growth rates,income tax rates, expense ratios, and rules of thumb from the base caseexample Thus, both properties in this example will be presumed to beacquired on the same economic terms, with the second property differingfrom the first only in scale

The data for the first property (dataEG2a) shown in Table 7-10 are thesame as the data in Example 1, except for the shorter holding period resultingfrom a terminal year of 3

Hence, the acquisition standards for the first property, as represented bythe rules of thumb reflecting first year performance, remain identical to those

in Table 7-2

To make the comparison as fair as possible, for the second property we willagain replicate the acquisition standards from the first property That is, wewish the first year rule of thumb ratios in the second property to be the same

as those for the first property The purpose of this is to hold constant a kind ofrisk standard, the assumption being that two properties with the same loan-to-value (LTV) ratio and debt coverage ratio (DCR) expose the investor toapproximately the same risk While not perfect, this approach is useful in astylized example such as this for reasons that will become apparent later Toaccomplish this we will ‘‘back in’’ to some of the values in the second property

in order to hold first year rule of thumb measures constant One consequence

of this is that some of the values may reflect unrealistic odd numbers, which

in practice would likely be rounded to the nearest $1,000

The ability to sell a property and defer payment of income taxes is indeedcause to celebrate But there is a price attached Any gain not recognized fortax purposes on disposition cannot be included in the tax basis of the newlyacquired property and thus is not eligible for depreciation The practical effect

of this is to transfer the basis from the old property to the new, an

accounting task known as an exchange basis adjustment The exchange basisadjustment then determines the depreciation deduction available for thesecond property.

Most of the accounting complexity in the exchange basis adjustment arisesfrom partially tax deferred, delayed, or reverse exchanges In the interest ofsimplicity, we will assume the exchange is concurrent and fully tax deferred.Qualifying for this is not difficult One need only acquire a property with

at least as much equity and at least as much debt as the property disposed.Stated differently, except as may be necessary to pay transaction costs, onemay not take any money out of the transaction (such money, known as ‘‘bootreceived’’ must be zero) and one must not be relieved of debt when thecomparing debt on the new property to debt on the old (net mortgagerelief must be zero)

EXCHANGE VARIABLE DEFINITIONS

Exchange variable definitions, having their primary influence on the exchangebasis adjustment, are shown below

disposition

Acquired equity (new equity) ¼equity in acquired property (forced to

be equal to the pre-tax sales proceedsfrom the prior property)

Net mortgage relief ¼net mortgage relief after credit for boot

paidAccumulated depreciation ¼the accumulated depreciation taken

on the first property during holdingperiod one

Indicated gain (potential gain) ¼ indicated if property is sold

New adjusted cost basis ¼new adjusted cost basis in acquired

property

propertyNew building portion ¼new building allocation of acquired

propertyNew annual depreciation ¼new depreciation allowance on

acquired propertySome of the data for the exchange of tax basis into the second propertycomes from the pre-tax conclusion of holding the first property, as shown inTable 7-11

The exchange of basis adjustment results in the new property having what

is called a ‘‘carryover basis,’’ the complete computations for which may befound in the electronic files for this chapter A summary of the values for thisexample is shown in Table 7-12 Note that the last item on the list is theannual depreciation deduction for the new property This deduction is smallerthan it would be if the same size property were purchased instead of acquired

by exchange This is a disadvantage of exchanging that must be overcome bysome compensating benefit One of our tasks here is to explore and quantifythat benefit

Note that the pre-tax equity reversion for the first property equals theequity acquired in the second property The equity reversion for the first

Accumulated

depreciation

property is computed after the payment of mortgage balance and sales costs,but before payment of capital gain tax.

Table 7-13 shows the input data for the two properties Comparing thetwo, we see many similarities In fact, the only differences are in the size of theproperty (in dollar value and number of units), the loan, the down payment,and the net income We assume ratios, financing conditions, tax rates, landallocations, and growth expectations are the same

We assume the properties are located in the same area, thus makingsomewhat realistic the fact that the acquisition standards of the secondproperty are similar to those of the first property In any stylized example, onecan find contradictions The price per unit for both properties at the time ofthe exchange transaction (disposition of the first property and acquisition ofthe second property) has been forced to be approximately the same, but thecapitalization rate for the acquired property is below the one sold (whichmeans that cri2b< cro2a) An argument could be made for reversing these, butbecause any such argument would rely on the introduction of specific facts,such argument is no better than the one that can be made for the data aspresented

Based on the above, the second property is acquired under the samegeneral income/price conditions as the first property The rules of thumb forthe two properties in Table 7-14 are the same except for price per unit(because the second property is acquired three years later) and after-tax cash

on cash return (because of the reduced depreciation arising from thecarryover basis) Important to our discussion later in this chapter, note thattwo risk variables, loan-to-value ratio and debt coverage ratio, are the same.The net effect is that, midway in our investor’s six-year real estateinvestment, he has sold a property, the value of which he had maximized, and

acquired a property to which he will apply the same entrepreneurial effort.

It is meaningful that the transfer of his maximized equity to a property inneed of his talent has been done without the payment of income taxes(something not easily accomplished when one invests in financial assets)

(dataEG2b)