Fundamentals of Real Estate
Lecture 7
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
Housekeeping Issues
Exam one week from today, 2/19
 MC, 30-40 questions, similar to homework, class
examples. Exam will cover ch. 1-4.
 You should read each chapter carefully as well
as know lecture and homework material.
2
Federal Income Taxation
Forecasting Taxable Income--At Sale
 Even more so than ongoing operations, tax
considerations play an important role when
considering disposition of the property.
 There are three basic approaches to taxes at
sale
1.
2.
3.
3
Fully taxable event
Tax deferral via an installment sale
Tax deferral via a like-kind (1031) exchange
Taxation at Sale of Property

To arrive at After-Tax Equity Reversion (ATER):
–
–
–
–
–
4
Begin with Gross Selling Price (GSP).
From GSP deduct expenses of selling the property
(SE)
This gives us Net Sale Proceeds (NSP), or Amount
Realized
Subtract Remaining Mortgage Balance (RMB) to
obtain Before Tax Equity Reversion (BTER)
Subtract Taxes Due at Sale (TDS) from BTER to
obtain After Tax Equity Reversion (ATER)
Taxation at Sale of Property

To calculate the Taxes Due at Sale (TDS):
–
–
Begin from NSP calculated above.
Deduct Adjusted Basis (AB) to obtain the Total
Taxable Gain (TG)


AB is sometimes referred to as the “book value” of the asset
AB is the undepreciated cost basis of the property less the
total depreciation taken during the life of the asset.
–
–
5
The undepreciated cost basis is the original acquisition price
(land, building, other improvements) plus acquisition costs, plus
any capital improvements made after purchase.
Any excess of NSP over AB is a taxable gain; any
deficit is a taxable loss.
Taxation at Sale of Property
–
The Total Taxable Gain (TG) is divided into two parts
1.
Depreciation Recapture Component
–
–
2.
Capital Gain Component
–
–
–
–
6
–
DR is the total amount of depreciation taken since purchase
DR can be taxed as high as 25%
The remainder of the TG once depreciation is deducted
(CG = TG - DR)
The amount the property has increased in value (net of
acquisition costs) since acquisition
CG can be taxed as high as 20%
DR tax liability plus the CG tax liability sums to TDS
ATER equals BTER less TDS
Taxation at Sale of Property
Calculating Cash Flow from Sale
=
=
=
7
Gross Sales Price (GSP)
Selling Expenses (SE)
Net Sale Proceeds (NSP)
Remaining Mortgage Balance (RMB)
Before-Tax Equity Reversion (BTER)
Taxes Due on Sale (TDS)
After-Tax Equity Reversion (ATER)
Taxation at Sale of Property
Calculating Taxes Due on Sale
8
=
=
Net Sales Proceeds
Adjusted Basis (AB)
Total Taxable Gain (TG)
Depreciation Recapture (DR)
Capital Gain (CG)
+
=
Capital Gain Tax Liability (CGTAX)
Depreciation Recapture Tax (DRTAX)
Taxes Due on Sale (TDS)
Taxation at Sale of Property
Calculating Cash Flow from Sale
=
=
=
9
$
$
$
$
$
$
$
4,800,000.00
(120,000.00)
4,680,000.00
(2,516,268.69)
2,163,731.31
(461,909.09)
1,701,822.22
(GSP)
(SE)
(NSP)
(RMB)
(BTER)
(TDS)
(ATER)
Taxation at Sale of Property
Calculating Taxes Due on Sale
10
=
=
$
$
$
$
$
+
=
$
$
$
4,680,000.00
2,696,363.64
1,983,636.36
1,303,636.36
680,000.00
(NSP)
(AB)
(TG)
(DR)
(CG)
136,000.00 (CGTAX)
325,909.09 (DRTAX)
461,909.09 (TDS)
Taxation at Sale of Property

1.
11
There are two commonly used means of deferring
taxes associated with selling an income property.
Installment Sale—the seller acts as the lender to the
buyer. Instead of paying for cash for the building, the
buyer enters into an agreement to pay for the building
over time. The seller pays income tax on the sale, to
the extent that the buyer pays the principal down on the
loan. Unfortunately, many sellers are not keen on
taking on the credit risk of someone they do not know.
Taxation at Sale of Property
2. Like-Kind (or 1031) Exchange. This rule is used very
frequently, and allows the sellers of one property to
exchange it for another “like” property. Most investment
properties can be exchanged in this manner—an office
building for an apartment building or retail center for
example would be acceptable. You have to identify the
target property within a relatively short period of time,
and keep sale proceeds from the sale of the first
property in escrow until the purchase takes place.
Specific rules apply to timing, etc which must be
adhered to carefully.
12
Taxation at Sale of Property
13
Example: Assume the following regarding a non-residential building:
The purchase price is 450,000. The investor obtains a 360,000
loan. There are no financing costs. The investor expects the
market value of the property to increase to $472,500 over the
anticipated two-year holding period. Selling costs are expected to
be 6% of the estimated sales price. The investor is in the 28%
ordinary tax bracket. Capital gains will be taxed at 20%. Assume
that the balance of the loan at the time of sale will be $354,276.
Also assume that 15% of the purchase price represents the value
of the land, and that improvements (the building) are depreciated
over 31.5 years using straight line depreciation. A) compute the
annual depreciation deduction, B) compute the adjusted basis at
the time of the sale (after two years); C) Compute the tax liability
from sale; D) Compute the after-tax cash flow (equity reversion)
from sale.