Analysis of Income-Producing Property: Tax Issues Notes

Analysis of Income-Producing Property: Tax Issues

Overview

  • The presentation covers the tax issues related to the analysis of income-producing properties.

  • Topics include the US Federal tax code, taxation of investment property, and after-tax cash flows to equity.

  • Operations: Taxable income and income tax liability.

  • Sale: Capital gains and capital gains tax liability.

The Tax Code

  • The US tax code applies different tax rates to different sources of financial gain:

    • Income: Periodic cash flows generated by the "rental" of human or financial capital.

      • Wage income.

      • Dividend/interest income.

      • Rental income.

    • Capital Gains: Discretionary cash flows associated with the sale of an asset.

Progressive Income Tax

  • The US has a progressive income tax structure where higher tax rates are applied to higher levels of taxable income.

  • Taxable income is net income after deductions for particular expenditures identified in the tax code.

    • Standardized deductions.

    • Itemized deductions (e.g., mortgage interest, local tax payments, charitable contributions, non-reimbursed business expenses).

2024 US Income Tax Rates (Single)

  • 0 to $11,600: 10%

  • $11,601 to $47,150: 12%

  • $47,151 to $100,525: 22%

  • $100,526 to $191,950: 24%

  • $191,951 to $243,725: 32%

  • $243,726 to $609,350: 35%

  • $609,351+: 37%

2024 US Income Tax Rates (Married, Filing Jointly)

  • 0 to $23,200: 10%

  • $23,201 to $94,300: 12%

  • $94,301 to $201,050: 22%

  • $201,051 to $383,900: 24%

  • $383,901 to $487,450: 32%

  • $487,451 to $731,200: 35%

  • $731,201+: 37%

Tax Liability Example

  • Scenario: Single filer with $120,000 taxable income in 2024.

  • Calculation: (.10)11,600+(.12)(47,150−11,600)+(.22)(100,525−47,150)+(.24)(120,000−100,525)=21,842.50(.10)11,600 + (.12)(47,150−11,600) + (.22)(100,525−47,150) + (.24) (120,000−100,525) = 21,842.50

  • Marginal tax rate: 24%

  • Effective (average) tax rate: $21,842.50 / $120,000 = 18.20% < 24%.

Importance of Marginal Tax Rate

  • Marginal tax rate is more important than the average tax rate because it applies to the next dollar of income or deduction.

  • Example: If the person forgot to include $250 in charitable contributions, then the adjusted tax liability would be different by: (.24) * 250 = $60.00

  • Adjusted Tax liability equation: (.10)11,600+(.12)(47,150−11,600)+(.22)(100,525−47,150)+(.24)(119,750−100,525)=21,782.50(.10)11,600 + (.12)(47,150−11,600) + (.22)(100,525−47,150) + (.24)(119,750−100,525) = 21,782.50

Capital Gains

  • Capital gains are divided into two components: gains due to property value appreciation and gains due to accumulated depreciation (depreciation recapture).

  • Long-Term Capital Gains Tax Rates:

    • 0% (for incomes up to a certain threshold)

    • 15% (for incomes between two thresholds)

    • 20% (for incomes above another threshold)

  • Depreciation recapture is taxed at 25%.

Capital Gains Tax Rates (Single)

  • 0 to $48,350: 0%

  • $48,351 to $533,400: 15%

  • $533,401+: 20%

Capital Gains Tax Rates (Married)

  • 0 to $94,050: 0%

  • $94,051 to $583,750: 15%

  • $583,751+: 20%

Section 1231 Asset

  • Ownership/equity investment in income-producing property is treated as a Section 1231 asset (used in a trade or business).

  • Property owners report income and can deduct:

    • Operating expenses.

    • Property taxes.

    • Mortgage interest.

    • Depreciation.

    • Amortization of certain fees.

After-Tax Cash Flow from Operations

  • After-tax cash flow from operations = Before-tax cash flow from operations - Tax liability

  • Tax liability = Marginal tax rate * Taxable income

Taxable Income

  • Taxable income is net operating income (NOI) less allowable deductions:

    • Mortgage interest

    • Amortization of fees

    • Depreciation

      • The economic loss of structure and improvements over time

Mortgage Interest Deduction

  • For amortizing loans, the interest component is the periodic interest rate times the outstanding mortgage balance.

  • For non-amortizing loans, the payment consists of interest only, reducing taxable income by the payment amount.

Amortization of Fees

  • Loan points and origination fees paid at closing are amortized over the loan's term to maturity using the straight-line method. (i.e. original fees / loan terms)

Depreciation

  • Depreciation is the loss of economic value over time due to use and obsolescence.

  • Depreciation is calculated on a straight-line basis according to a defined economic life.

    • Commercial, retail, and industrial structures: 39 years.

    • Residential property: 27.5 years.

    • Land is not depreciable.

  • Capital expenditures are depreciated on a straight-line basis over the IRS-defined economic life.

  • Standard depreciation for leasehold improvements is determined over 15 years (subject to Congressional extension; otherwise, reverts to 39 or 27.5 years).

Losses

  • Losses are divided into three categories:

    • Active income: Income attributed to the direct efforts of the taxpayer (wages, salary, commissions).

    • Passive income: Income from passive activities (rental and leasing).

    • Portfolio income: Income from dividends, interest, and royalties (investments in financial assets).

  • Losses can only offset gains within the same income category.

Negative Taxable Income

  • Losses from direct real estate investment are passive unless the investor works in real estate meeting specific requirements.

  • Losses can offset other passive income.

  • If losses exceed passive gains, they can be carried forward to offset future gains.

Deductions

  • Mortgage Interest

  • Amortization

    • Origination fees

    • Leasing commissions

  • Depreciation

    • Structure and improvements

    • Capital expenditures

    • Tenant improvements

Example: PJF Lofts

  • A real-world example of an investment property is now provided. Key data about the property is listed, including but limited to, the following:

    • Number of Units: 85

    • 1BR/1BA: 20, 2BR/2BA: 40, 3BR/2BA: 20

    • Rent/Month: 1BR/1BA: $1,050 , 2BR/2BA: $1,450, 3BR/2BA: $2,000

    • Asking price: $13,250,000

    • Market Return on asset: 9.00%

    • Inflation: 3.00%

    • Terminal Capitalization Rate: 7.75%

    • Loan-to-Value at origination: 60.00%

    • Debt: $7,950,000

    • Equity contribution to sale: $5,300,000

    • Mortgage Rate: 5.25%

    • Origination Fees: 2.00%

    • Amortization: 10

    • Maturity: 10

    • Cost of Sale: 3.50%

    • Vacancy Rate: 5.00%

    • Collection Losses: 2.00%

    • Marginal tax rate: 35.00%

    • Capital Gains Tax Rate: 15.00%

    • Depreciation Recapture Rate: 25.00%

    • Other Passive Income: None

    • Land Value: $2,750,000

    • Structure and Improvements: $10,500,000

    • Economic life - structure: 27.5

    • Economic life - capital expenditures: 10

Mortgage Interest Deduction (PJF Lofts)

  • Only the interest paid is deductible.

Depreciation Allowance for Structure (PJF Lofts)

  • Value of structure for tax purposes is purchase price less land value: 10.5M10.5M

  • Depreciation allowance is the structure value divided by the IRS-defined economic life of the property:

    • 10,500,000/27.5=381,818.1810,500,000 / 27.5 = 381,818.18

  • Depreciation is deducted from taxable income for every year of ownership (up to 27.5 years for residential, 39 for commercial).

Depreciation Allowance for Origination Fees (PJF Lofts)

  • Fees are amortized over the maturity (not amortization period) of the mortgage:

    • 159,000/10=15,900.00159,000 / 10 = 15,900.00

Depreciation Allowance for Capital Expenditure (PJF Lofts)

  • First-year capital expenditures: $21,250; economic life of 10 years.

    • Depreciation allowance in year 1: 2,125.002,125.00

  • Second-year capital expenditures: $21,887.50.

    • Depreciation allowance in year 2 is $2,188.75 + $2,125.00 = $4,313.75.

    • The deduction accumulates annually for each year of its usable life.

After-Tax Cash Flows from Operations (PJF Lofts)

  • The after-tax cash flows will be calculated for the first five years of the holding period.

After-Tax Cash Flow from Sale

  • After-tax cash flow from sale = Before-tax cash flow from sale - Tax liability.

  • Tax liability has two components:

    • Appreciation in property value: Taxed at 15% capital gains rate.

    • Gains due to depreciation: Taxed at 25% depreciation recapture rate.

Capital Gain Calculation

  • Capital gain is the difference between the net gain from the sale (before principal repayment) and the book value of the property.

  • Book value = Acquisition price - Accumulated structural depreciation + Capital expenditures (excluding tenant improvements or depreciable expenses on office equipment).

Calculating Capital Gains Taxes

  • Book Value

    • Accumulated depreciation includes allowances for both structure and capital improvements.

  • Capital Gain

    • Capital appreciation

    • Depreciation recapture

Book Value and Tax Liability (PJF Lofts)

  • Accumulated depreciation is the sum of all depreciation allowances for structure and capital improvements taken over the holding period.

  • The after-tax cash flow from the sale is the difference between the before-tax cash flow from the sale and the tax liability from capital gains.