REP Chapter 14

Why would an investor consider doing an exchange or an installment sale?

both and exchange and an installment sale are ways of deferring capital gain taxes so that they are recognized in the future rather than at the time of sale

Why might the actual holding period for a property be different from the holding period that was anticipated when the property was purchased?

An investor purchases a real estate investment based on the benefits expected to be received over an anticipated holding period. That is, the investor computes the various measures of investment performance based on expectations at the time the property is purchased. After the property is purchased, however, many things cna change that affect the actual performance of the property. THese same factors may affect the investor's decision as to whether the property continues to meet his investment objectives. For example, market rents may not be increasing as fast as expected, thus reducing the investor's cash flow. Tax laws may have changed, as they did in 1986, thus changing the benefit for some investors more than others. The point is that a periodic evaluation should be made to determine whether properties should be sold.

How important are taxes in the decision to sell a property?

Taxes are important for a number of reasons. If a property is sold, capital gains tax must usually be paid. This increases the opportunity cost of selling versus keeping the property. Also, tax laws may have changed since the property was purchased. This means that the depreciation deductions available to a new investor might be better or worse than that which the current owner is using. This affects the return that a new investor can get relative to that which the current owner can get by keeping the property.

What factors should an investor consider when trying to decide whether to dispose of a property that he has owned for several years?

The factors are based on an incremental, or marginal, return criteria that should be utilized by investors when faced with such decision making. The investor must consider whether the net funds obtained from the sale of the property (after tax and expenses) can be reinvested at a greater rate of return (AITRR) than the return that would be earned if the property is not sold. Tax laws in effect at the time of pruchase/sale of a property. Tax law changes affect the relative benefits of existing versus new investors in the same property.

What is the marginal rate of return and how is it calculated?

The marginal rate of return is the return gained by holding the property for one additional year. It considers what the investor could get in the future by keeping the property versus what he could get today by selling the property. It is calculated on the benefit of receiving the ATCF from operations for one additional yera and the ATCF from the sale of the property at the end of the additional year.

What causes the marginal rate of return to change over time? How can the marginal rate of return be used to decide when to sell a property?

increasing rents and increases in the value of the property tend to increase the MRR. Equity buildup from the price appreciation and loan repayment however tends to lower the MRR. Also, because the depreciation deduction is fixed but rents are rising, the relative amount of tax benefits from depreciation decreases each year. The property should be sold when the marginal rate of return falls below the rate at which funds can be invested.

In general, what kinds of tax incentives are available for rehabilitation of real estate income property?

investment tax credits -- even for renovation of low income housing

Why would refinancing be an alternative to sale of the property?

refinancing would increase financial leverage. refinancing at a higher loan-current-value ratio may provide the investor with additional funds to invest. This, to some extent, is an alternative to sale of the property. No taxes have to be paid on funds received by additional borrowing, whereas taxes would have to be paid if the property is sold.

Do you think renovation is more or less risky than a new investment?

renovation can be more risky because of the uncertainty as to the cost of the renovation. It is often easier to estimate the costs of new construction relative to the costs of renovating an older building that may have hidden structural and environmental problems

What are the benefits and costs of renovation?

renovation can have many benefits, including increasing rents, lowering vacancy, lowering operating expenses, and increasing the future property value

How can tax law changes create incentives for investors to sell their properties to other investors?

tax law changes affect the relative benefits of existing versus new investors in the same property. If the tax law becomes less favorable this tends to favor existing investors. If the tax law becomes more favorable (depreciable lives are shortened) then new investors tend to be favored. Tax law changes affect the turnover or sale of real estate. It is important to understand these concepts since tax laws are always subject to change and these changes affect the relative risk and return opportunities for new and existing investors.

Why might the ATIRR differ for a new investor versus an existing investor who keeps the property?

this could be due to tax law change that affect the relative benefits of existing versus new investors in the same property. If the tax law becomes less favorable as it did in 1986, this tends to favor existing investors. If the tax law becomes more favorable, as it did in 1981, then the new investors tend to be favored. Tax law changes tend to affect the turnover or sale of real estate. it is important to understand these concepts since tax laws are always subject to change and these changes affect the relative risk and return opportunities for new and existing investors.

What factors should be considered when deciding whether to renovate a property?

to determine whether a property should be renovated consider the incremental benefit associated with renovating the property versus not renovating the property

Why is refinancing often done in conjunction with renovation?

when properties are renovated the investor often uses that opportunity to refinance the entire property. Thus, the investor may be able to borrow funds in addition to what is needed for the renovation, especially if the investor plans to obtain a new loan on the entire property rather than obtain a second mortgage to cover the renovation costs. The total amount of funds that the investor will be able to borrow is usually based on a percentage of the estimated value of the property after renovation is completed.

What is meant by the incremental cost of refinancing?

when the interest rate is higher on the larger loan amount, the incremental cost of the additional funds borrowed is even higher than the rate on the larger laon. This is due to the fact that the higher rate has to be paid on all the funds borrowed, not just the additional funds. For refinancing to be a profitable strategy, the effective cost of the debt must be less than the unlevered return on the projects being financed

Are tax considerations important in renovation decisions?

yes, first the improvements may result in an increased depreciable basis and more tax deductions. Second, there may be tax credits available for renovating the property.