Chapter 17: Investments & business opportunity brokerage

at-risk rules

- A taxpayer may deduct losses from an activity only to the extent of the amount of investment capital that is at risk. - Retained provisions of the Tax Reform Act of 1986 include credits for a taxpayer who restores a historical building. - The Act also provides credits for qualified low-income housing projects.

like-kind exchange

- An investment real estate that is exchanged for other investment real estate - The problem with this type of transaction is that most properties do not have the same value. - Therefore, in order to conclude the exchange, investors often include cash, or other forms of unlike property, to equalize the transaction.

reasons for a business appraisal

- Business owners or potential purchasers may request an appraisal in order to establish a sales or purchase price, obtain a loan, or for insurance purposes. - Other reasons include condemnation, buy-sell agreements, property settlements, estate settlements, or to be used in connection with employee stock option plans.

investment interest limitation

- Deduction of investment interest is limited to the amount of net investment income within the tax year. - The investment interest limitation applies to all interest paid for tax years beginning after December 31, 1986, regardless of when the debt was incurred.

security agreement

- If financing is involved in a bill of sale, a standard Security Agreement is used to identify the property that is security for the debt. - The Security Agreement is similar to a mortgage and is usually recorded to protect the lender's interest in the property.

equity dividend ration

- If the investor wishes to determine the rate that is being received based upon the actual equity invested (vs. the rate on the overall investment), then an equity dividend ratio would be used. - formula: Equity dividend ratio (EDR) = Cash throw off (CTO)/Original equity - The equity dividend ratio provides the investor with a return on the money they invested in the project (i.e., return on their down payment or cash invested).

feasibility study

- Investors attempt to evaluate and minimize risk. - used as a basis for making a real estate investment decision. - The feasibility study assesses financial, governmental, legal, social, physical, and locational factors that may influence the investor's decisions, based on anticipated risk and potential reward.

liquidation value approach (appraisal for business)

- Liquidation value is the value that remains after liquidating all the assets of the business and satisfying all the liabilities. - This approach is used to value a failing business that is not expected to continue to do business. - It can also be used to establish the minimum value of a profitable business.

equity build up

- One advantage of investing in real estate is the equity build-up that can occur on mortgaged rental property. - An investor who collects rent from a tenant can use the rental income to pay expenses and reduce the principal amount of the loan, which can increase the equity in the property. - Over time, the tenant essentially pays for the property to the benefit of the investor. - Some investors consider equity build-up as a good use of cash flows when the interest rates on savings accounts and certificates of deposits are lower than the rate of return on the investment property.

depreciation

- One benefit that is not available to homeowners but is available to investors and the owners of businesses is the ability to deduct a portion of the money that they have invested in their property each year from their gross income. - This deduction is referred to as cost recovery, or tax depreciation.

step 6: ensure legal compliance

- Review the transaction carefully before proceeding in order to be certain that all laws have been complied with. - This includes real estate, securities, mortgage brokerage licensing laws, and UCC requirements.

MACRS residential depreciation

- Tax law currently allows the owners of residential and low-income investment properties to depreciate a portion of their investment over 27.5 years on a straight-line basis. - The residential category includes single-family rentals, all apartment rentals, and mobile homes.

rate of return (ROR)

- The money made in an investment is referred to as the return. - The investment amount made with the original purchase is referred to as the capital, or capital investment. - The return from an investment is calculated based upon the capital investment. - Investors want to achieve a high rate of return. formula: Rate of return (ROR) = Net operating income (NOI)/Investment value

MACRS nonresidential depreciation

- The owners of nonresidential investment properties may depreciate a portion of their investment over 39 years, also on a straight-line basis. - Hotels and motels are classified as nonresidential.

step 4: deduct liabilities

- The value established in Step 3 must be reduced by the amount of liabilities, long- and short-term. - This includes the value of any preferred, outstanding stock.

challenge of the appraisal of a profitable business

- The value of the business is not just the value of any real estate owned, but rather, a composite of the values of the real estate, personal property, and intangible assets, such as licenses, franchises, noncompetition contracts, and so on

capital gain tax

- Under the American Taxpayer Relief Act of 2012, the top capital gain tax rate has been permanently increased to 20% (up from 15%) for single filers who have incomes above $400,000 and married couples filing jointly who have incomes exceeding $450,000. - The Act also changed the depreciation recapture rate to 25% for all taxpayers, independent of tax bracket.

bill of sale

- When personal property is sold in a commercial transaction, a Bill of Sale is used to identify the property conveyed. - This document is similar to a deed.

uniform commercial code

- a body of standardized rules that regulate commercial transactions throughout the nation by focusing on the sale and financing of personal property. - Florida has adopted a version of the UCC as law. - An attorney must be retained to prepare documents used in compliance with the UCC; real estate licensees may not prepare these on behalf of customers or principals.

tax shelter

- a legal method of minimizing or decreasing an investor's taxable income, and therefore, their tax liability. - Depreciation of a real estate investment can reduce an investor's taxable income and is, therefore, a form of tax shelter.

reserve for replacements

- a noncash expense. - This money is for future use to replace worn-out components, called short-lived items, such as carpeting, appliances, central heat and air systems, roof coverings, and so on.

what are the three income classifications?

- active income - passive income - portfolio income

adjusted basis

- adjusted bases = cost basis + increases - decreases - measurement of how much is invested in a property for tax purposes, including any IRS-allowed improvements, referred to as capital improvements. - Examples of capital improvements include a new addition to the home, paving the driveway, replacing the roof, installing central air conditioning, and rewiring the home. - By adding the cost of improvements to the basis, the amount of gain is reduced, thereby decreasing the amount of capital gains tax otherwise owed. - The adjusted basis may also include certain IRS-allowed reductions including such items as depreciation of investment property, casualty losses, and residential energy credits.

Modified accelerated cost recovery system (MACRS)

- adopted in 1986, thereby replacing the Accelerated Cost Recovery System that was implemented in 1980. - Cost recovery, in the language of the tax code, refers to tax depreciation. - The MACRS stipulates the time periods over which investment real estate can be depreciated for tax purposes. - The time period begins when the property is placed in service, which, essentially, means the time in which title is taken.

what are the different types of real estate available for investments

- agricultural - business opportunities - commercial - industrial - office - residential

investment interest

- all interest charged on debt that is not incurred in connection with the taxpayer's primary trade or business.

tax deferred exchange

- allows any capital gain realized from the sale of investment property to be transferred into another property by exchanging properties.

amount realized

- also called net proceeds from sale - amount realized = sale price-costs of sale

tax depreciation

- also referred to as cost recovery, is an income tax deduction that allows a taxpayer to recover the cost of investment property over a number of years.

capital gain/loss

- an increase in the value of an asset, such as personal or investment property, that gives it a higher value than the cost of purchasing the asset. - If a property sells for more than the purchase costs, there is a capital gain. - A capital loss is incurred when there is a decrease in the value of an asset that gives it a lower value than the cost of purchasing the asset - A capital gain or loss is not realized until the property is sold. - A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on the investor's tax return - formula: gain= amount realized - adjusted basis

appreciation

- an increase in the value of an investment over time. - Investment property can appreciate in value for many reasons, such as inflation, supply and demand, and capital improvements. - Most real estate investors purchase income property with the goal of realizing a positive cash flow and appreciation.

loan constant

- an interest and principal factor used to calculate a level monthly payment necessary to pay off both principal and interest over the term of the loan. - Today, financial calculators and computers are typically used to calculate payments and amortization schedules. - In the past, booklets were published where the interest rate and term of the loan were matched to arrive at a constant. - The constant was then applied to the original loan amount to determine the monthly payment.

ongoing cash flows

- are received by the investor throughout the investment-holding period, as in rental income.

one time cash flows

- are sales proceeds received as a result of the sale of an investment property.

tangible assets

- assets that have physical existence such as buildings, furniture, office equipment, and so on.

financial risk

- associated with extremely high expenses and/or extremely low income. - The investor may be faced with adding to the original investment to keep it in operation. - In the alternative, the investor may have to borrow more money or sell other assets to raise capital to prevent losing the investment. - If an investor is unable to make the required payments on their debt obligations, they risk defaulting on the loan.

residential investments

- available in a wide range of prices. - Important factors to be considered when selecting residential properties are location, availability of transportation, schools, and shopping. - Typical residential investments include condominiums, villas, single-family homes, and apartment complexes.

what're the types of dynamic risks?

- business risk - financial risk - inflationary risk - interest rate risk - liquidity risk - market risk

liquid asset

- can be sold rapidly with minimal loss of value. - The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times.

realized incomes

- capital gains are realized income - realized income is subject to income tax in the year in which its earned

variable expenses

- change with the level of occupancy and include costs, such as management fees, maintenance, utilities, yard care, janitorial, and so on

business brokerage

- consist primarily of analyzing financial statements

what happens after the new operating income is estimated?

- debt service is subtracted to obtain the cash throw-off (CTO). - This is also called the before-tax cash flow (BTCF). - Investors will be concerned with an additional computation to determine the after-tax cash flow (ATCF), which is beyond the scope of the pre-license course.

liabilities

- debts that are owed by a business. - Liabilities include accounts and notes payable, and long and short-term debt. - Short-term liabilities are debts that must be recognized within one year or less. - Long-term liabilities are debts that will not come due for more than a year, such as mortgage balances.

owners equity

- difference between assets and liabilities

what are the two primary types of risk

- dynamic - static

operating expense ratio

- expresses the relationship between the expenses incurred in operating the property (the operating expenses) with the amount the investor actually receives (the effective gross income). - This relationship is expressed as a percentage, or ratio - formula: Operating expense ratio = Operating expenses/ Effective gross income

what are types of operating expenses?

- fixed expenses - variably expenses - reserve for replacements

installment sale

- form of seller financing - no down payment required to qualify as an installment sale - qualifies as long as at least one payment is received in a tax year subsequent to the year of sale. - only the percentage of gain received in any given year is taxable. - Therefore, the gain can be spread over several years, thereby reducing the amount of tax due in any tax year.

expectation for real estate licensees

- found in the Tax Law of 1993 that provides additional relief for real estate licensees who spend a minimum of 750 hours per year in the real estate business and incur passive loss from rental activities. - Real estate licensees who own investment real estate should contact their tax accountants for clarification of this provision

investment income

- gross income from interest, dividends, rents, royalties, and income not derived from a trade or business.

intangible assets

- have no physical existence, but have monetary value. - Intangible assets include stock shares, trademarks, copyrights, research and development expenses, noncompetition contracts, franchises, and goodwill.

step 5: determine the value of the stock

- if a corporation is being sold by transferring shares of stock, the share value must be determined. - Divide the net value of the business by the number of shares to determine the per-share value.

fixed expenses

- include costs that do not change with the level of occupancy, such as real estate taxes and hazard insurance.

disadvantages of investing in real estate

- include the illiquidity of property (it cannot be bought or sold as quickly as other assets), - the local (immobile) nature of the real estate market compared to other types of investments that can be bought and sold in a variety of markets, - the expense or overhead required to manage the property or hire a property manager, - the need for additional investment assistance from experts such as brokers, tax accountants, and other professionals

active income

- income from salaries and wages.

significant rewards of investments real estate for investors

- income generated by the property - a build-up of equity, - appreciation in value, - tax benefits, - positive leverage, and prestige. - Investment in real estate can also serve as a hedge against inflation when the property has level-payment mortgage where the payments remain the same, but the rental income increases with inflation

industrial investments

- involve manufacturing, assembly, and distribution. - These properties are located most often near major transportation arteries. - Weight-reducing operations, such as mining operations, prefer locations near the source of their raw materials. - Weight-gaining operations, such as assembly plants, prefer locations close to their market areas in order to reduce transportation costs.

assets

- items of value that are owned by a business. - Assets include accounts and promissory notes receivable, cash, inventory, production machinery, real estate, personal property, patents, trademarks, and goodwill (the value of the name of the business in the marketplace).

investment analysis includes what?

- land use controls, such as zoning, deed restrictions, and permitting requirements that affect the value of a property. - considers economic forces, such as population growth, investment of foreign capital, and the impact of taxation on real estate investments. - The most important factor underlying every investment decision is economic soundness. - Real estate licensees should be capable of evaluating the advantages and disadvantages of a potential real estate investment compared to alternative investments.

what is the significance of the separation of income into 3 categories?

- loss cannot be offset against income from another classification; it can be offset inly by income in that same classification - eliminates many forms of tax shelters - exposes more income to federal income tax - taxes that cannot be offset by gains in any year must be carried to next year - they may not be deducted against income from other sources such as salary, interest, dividends, or other active business income. - If a property is sold at a gain, any losses from previous years may be used to offset losses carried forward.

what is not considered an operating expense?

- mortgage payments called debt service

does real estate borrow money?

- no people do. - The type and amount of financing is dictated by the needs of the investor, not the property. - It would be inappropriate to charge the property for something unrelated to its operation.

negative leverage

- occurs if the investment returns less to the investor than the cost of borrowing the money necessary to purchase the investment.

positive leverage

- occurs if the investment returns more to the investor than the cost of borrowing the money necessary to purchase the investment

business brokerage

- offers real estate services that are connected with the sale or lease of businesses. - The sale of a business may or may not include the sale of real property. - The sale of a business may involve the transfer of ownership of shares of stock, limited partnership interests, or other forms of securities.

illiquid asset

- one which is not readily saleable due to uncertainty about its value or a lull in the market in which it is regularly traded. - One disadvantage of investing in real property is that property is considered an illiquid asset, which cannot be transferred as easily as other assets, such as stocks or bonds.

basis

- or cost basis - original value of an asset for tax purposes. - When purchasing a home, the basis includes the purchase price and any associated acquisition costs. - Basis is used to determine the gain or loss on the sale, exchange, or other disposition of a property.

infaltionary risk

- or purchasing-power risk, - risk that future inflation will cause a decrease in purchasing power of the currency, resulting in a rise in the cost of goods and services. - Inflation causes the investor's expenses to increase. - Potential buyers may also lack the purchasing power to buy the property.

do most investors and business owners desire negative or positive cash flows?

- positive cash flow in order to achieve a profit and a high rate of return on their investment. - However, there are tax benefits to negative cash flows.

calculating profit on investment

- profits from investments are calculated on the amount that is originally invested, not on the amount received when the investment is sold or liquidated - formula: Profit or loss % = Amount made/ Amount paid - The money gained or lost (amount made) is the amount that remains after subtracting the original amount paid for the property (amount paid) from the amount received on the sale of the property (liquidation or sale).

liquidity

- refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. - Cash is the most liquid asset.

balance sheet

- reflects the financial condition of a business as of a particular time.

securities

- required to have a separate license. - Real estate licensees must be certain that securities laws are not violated when listing or selling a business. - A real estate licensee may also need to hold a securities license if the transaction includes the transfer of corporate stock or limited partnership interests. - Legal counsel is strongly advised before proceeding with the sale of a business.

commercial investments

- retail centers, such as regional shopping centers usually located near major transportation routes. - Major retail centers attract anchor tenants that draw people to the center. - Typically, these are the name-brand department stores - They are called generative functions, since they generate customer traffic to the center. - Suscipient functions are businesses that attract passersby, such as card and gift shops, ice cream and novelty stores, and so on.

dynamic risk

- risk associated with changes in general market conditions.

static risk

- risk that can be offset with insurance, such as fire, flood, robbery, and so on.

reconstructed operating statement

- shows annual forecasts of income and expenses over a period-of time. - Required rates of return based on forecasted income, expenses, risk, and length of the ownership period are applied to estimate the value of the property. - The rate used to estimate value is dictated by the individual investor's requirements, but tempered by a competitive market.

business opportunities

- smaller businesses with sales of $200,000 or less - These businesses typically have a limited amount of assets. - The ownership of such businesses may also involve securities, but many are sole proprietorships or partnerships that do not. - The sale of many of these businesses involves only the sale of inventory and fixtures, and an assignment of a lease.

business opportunities investments

- smaller local businesses (barbershops, hair salons. print shops, corner stores, boat rental businesses) - they look for ones they can own or manage to create income for themself - Business opportunities are normally valued based upon applying a multiplier to the net income being produced by the business. - Value may also be applied to intangible assets such as a business's name or reputation in the community.

agricultural investments

- some want to engage in land - others own land and lease it to others - can be purchased for path of growth allowing for lower taxes through agricultural exemptions, before ultimately selling or developing the property.

what are the steps in the sale of a business?

- step 1: acquire the listing - step 2: list the assets - step 3: determine the value of the business - step 4: deduct liabilities - step 5: determine the value of stock - step 6: ensure legal compliance - step 7: close the transaction

what are the two methods an investor can use when a poverty is sold to reduce or defer the amount of tax due on transaction?

- tax-deferred exchange - installment sale

equity

- the difference between the current market value of a property and the amount the owner still owes on the mortgage. - The initial down payment creates equity. - Additional equity is created through principal reduction and appreciation.

interest risk rate

- the effect of the economy on the investment. - If the value of a dollar increases or decreases because of inflation or deflation, interest rates could increase or decrease, which may affect the value of the investment or reduce the likelihood of selling it.

net investment income

- the excess of investment income over investment expense.

loan to value ratio

- the loan-to-value (LTV) ratio measures financial risk in an investment by comparing the mortgage loan amount to the price, or value, of the property. - This ratio indicates the percentage of the property value that is represented by debt. - A higher LTV ratio increases the risk of the borrower's default. - formula: Loan-to-value ratio = Loan amount/ Property value

cash flow

- the movement of money into or out of a business or investment, measured over a period-of-time. - cash flow is the money that remains after all the income, such as rents, is collected and all the day-to-day expenses associated with owning the property are paid.

market risk

- the possibility for an investor to experience losses due the effect of the national or local real estate market. - There are many sources of market risk that can affect the real estate market, including recessions, unemployment rates, availability of financing, changes in the economy, and other local conditions affecting specific markets.

risk

- the possibility of losing all or part of the investment. - Every investment involves a certain degree of risk.

business risk

- the possibility that an investment will yield lower than anticipated profits, or that it will experience loss rather than a profit. - Business risk is measured by comparing actual income and expenses to budgeted income and expenses. - If expenses are higher than projected, and/or income is lower than projected, the investment could be in jeopardy

liquidity risk

- the risk that an investment property cannot be bought or sold quickly enough to prevent or minimize loss.

capital

- the total amount that is invested. - Capital includes the funds that were used to start the enterprise, money that is invested during operation, and retained capital.

leverage

- the use of borrowed funds to purchase assets. - Most investors make real estate investments with borrowed money. - Positive leverage allows an investor to earn a higher rate of return on funds invested by borrowing than they could earn by paying cash for the investment. - Financial leverage can be either positive or negative. - in most instances, an investor will use leverage to purchase real estate because of the expectation of positive leverage. - However, highly leveraged investments require cash flows from the property to make the mortgage payments; debt service that is too high may make that impossible.

business enterprise

- transactions that are in excess of $200,000. - The brokerage of larger businesses usually involves the transfer of stock shares or other types of security. - The transaction may or may not involve the sale of real estate. - If not, negotiation of a lease may be required. - Markets for business enterprises are typically wider in geographic scope than markets for individual parcels of real estate.

real-estate investment trust (REIT)

- type of business trust, allows groups of investors to invest in income-producing property. - A REIT provides a method for individuals to pool financial resources to invest in larger, professionally managed properties. - Investment trusts invest in office buildings, large apartment complexes, and retail centers. - Purchasing shares in a REIT is similar to purchasing shares in a mutual fund.

boot

- unlike property received in a tax-deferred exchange - taxable to the recipient

office investments

- usually located in central business districts or professional office parks in suburban areas near their tenant base. - Offices are usually good long-term investments since office tenants generally lease for extended periods.

limited expectation

- when a small investor has an opportunity to retain a tax shelter advantage - exception exists even if a rental agent of property management firm handles the property - management decisions include approving new tenants, deciding on rental terms, approving expenditures and other similar decisions

going concern value

- when the value of all assets is combined

step 2: list the assets

A detailed list of all tangible and intangible assets is required.

basic accounting formula

Assets - Liabilities = Owner equity

step 3: determine the value of the business

Estimate the value of the business by using the appropriate appraisal methods.

step 7: close the transaction

Locate a buyer who is interested in the business and conclude the sale.

step 1: acquire the business

The listing process is virtually the same as listing other property for sale.

income statement

a history of income and expenses over a stated period, such as a month or a year.

depreciation calculation on PG 332

depreciation calculation on PG 332

who is real estate investments popular amongst?

high and moderate income investors

costs of sale

include brokerage commissions, relevant advertising, legal fees, seller-paid points, and other closing costs paid by the seller.

portfolio income

income from dividends.

passive income

income from rental activity and any investments in which the investor does not materially participate.

positive cash flows

occurs when there is more money coming in than going out, resulting in money remaining.

negative cash flow

occurs when there is more money going out than coming in, resulting in a deficiency that the investor or business owner must pay out of pocket.

what does evaluating an investment property begin with?

reconstructed operating statement

most investment decisions depend on what?

the rate of return or profit, which the investor expects to earn by assuming a risk in real estate or other type of investment

sale price

total amount the seller receives for the sale, including money, notes, mortgages, or other debts the buyer assumes as part of the sale