Unit 3: The Basics are Analyzing Investments

Last year, a couple you worked with purchased their home, which was valued at $175,000. According to research you've done on the area, property values have risen about 2%. Based on this information, how much did the property increase in value over the last year? $3,500 $35,000 $8,750

$3,500

A property is generating $100,000 in income and has expenses of $25,000. The investor pays $3,000 toward mortgage principle each year and $32,000 toward interest, plus another $4,000 in income taxes. What is the before-tax cash flow? $45,000 $40,000 $36,000 $50,000

$40,000 To arrive at before-tax cash flow, you subtract from income ($100,000) expenses ($25,000) and debt service ($3,000 + $32,000 = $35,000). So $25,000 + $35,000 = $60,000. Then $100,000 - $60,000 = $40,000. You don't subtract income taxes of $4,000.

When homeowners sell their personal property, they can claim a capital gain or loss on the sale of the property. The IRS provides specific guidelines about how to determine whether the gain or loss is long-term or short-term. Drag each statement into the correct box to indicate whether it is associated with a long-term capital gain or a short-term capital gain. 1. Prior to 2013, the highest rate paid on this calculation of sold property was 15% 2. Taxes at the taxpayer' marginal tax rate 3. An additional 3.8% may apply on net investment income for those in the highest tax bracket, making an effective tax rate calculation of 23.8% 4. As of 2013, a new rate of up to 20% for taxpayers in the new 39.6% income tax bracket applies

1. Long-term capital gain 2. Short-term capital gain 3. Long-term capital gain 4. Long-term capital gain

Tyrell and Barb bought a commercial investment property in 2009 during the real estate market downturn. Through what year will they be able to depreciate the investment? 2048 2029 2039 2019

2048 Depreciation may be taken for 39 years for commercial, non-residential property.

Gary, your investor client, has an annual net income of $50,000. His annual debt service is $12,500. What is his debt service ratio? 4.0 1.4 4% .004

4.0

John wants to do a 1031 tax exchange. He just sold his property. How many days does he have to identify a new property? 30 45 60 180

45

Investors analyze many areas when deciding whether to purchase a property. Which of these are items do they analyze?

A Price B Financing C Special risks D Rate of return vs. risk E Interplay of variables

Review each statement about tax-deferred exchanges and determine if the statement is true or false. A A tax-deferred exchange for properties used for investment or business purposes is also referred to as a "like-kind" or 1031 exchange. B The 1031 tax exchange is used to defer paying taxes when there is an almost immediate repurchase of what's called a "like-kind" property. C Income-producing residential, commercial, and industrial property can qualify for an exchange. Hotels and motels also can qualify. D A 1031 exchange can also be applied to a primary residence—similar to the capital gains exclusion. E Investors can defer capital gains using the 1031 exchange for real estate exchanges only. Personal property, such as equipment, cannot be tax-deferred. F Leased property can also qualify for an exchange as long as the lease is for 25 years or more.

A. B. C. D. False; the property has to be bought and sold for investment or business purposes E. False; investors can defer gains on personal property, such as equipment, provided they buy other equipment as the exchange vehicle F. false; leased property can also qualify for an exchange as long as the lease is for 30 years or more

Do you know the differences between the "identify" and "exchange" deadlines for 1031 exchanges? Let's find out. Review each statement and determine if the statement is true or false. A Any cash an investor receives from the proceeds of a sale is called boot, and it is taxable. B The 45-day identification period does not include Saturdays and Sundays. C An investor can revoke and submit a new property for exchange as long as a formal identification is made to the qualified intermediary within the 45-day identification period. D If an investor fails to identify a property within 45 days, or if the deal falls through and the investor isn't able to identify a new property within the 45-day window, the investor's chance to complete a 1031 exchange for that property is over. E An investor must complete the 1031 exchange by the earlier of either midnight of the 180th calendar day following the close of the relinquished property, or the due date of the investor's federal income tax return for the tax year in which the relinquished property was sold, including any extensions. F If investors decide they do not want to complete an initiated 1031 exchange, they can receive their cash immediately; they do not have to wait until after the exchange period.

A. True B. False; the 45-day identification period does include weekends C. True D. True E. True F. False; if investors decide they do not want to complete their 1031 exchange, they have to wait until the end of the exchange period to get their cash

You now know what the two types of depreciation are, but what else do you know about depreciation? Let's find out. Review each statement about depreciation and determine if the statement is true or false. A One example of economic depreciation is when the asset is actually worth less because it's deteriorating physically. B Tax depreciation is when investors take an annual business deduction by depreciating an (often) appreciating asset. C Depreciation is limited to homeowner-occupied and investment properties. D The IRS requires investors to depreciate their investment properties. E Tax depreciation is cost recovery. F The basis of an asset includes the sales price, acquisition costs, and any capital improvements.

A. True B. True C. False; depreciation is limited to investment properties only D. True E. True; the investor recovers the cost --or, rather, the basis of the asset over the asset's useful life F. True

Now let's see what you recall about income shelters. Determine whether these statements are true or false. A Income shelter means that the income received is permanently sheltered from taxation. B Income shelters that are available to investors include tax losses that investors can use to offset both passive and active income. C Allowable deductibles include depreciation, operating expenses, real estate taxes, and mortgage interest.

A. false B. True C. True

An increase in property value is called ______. Appreciation An anomaly Depreciation Amortization

Appreciation

The sales price, acquisition costs, and capital improvement costs (such as renovations or additions) of a property combine to make up what? Debt coverage Appraisal value Market value Basis

Basis

Special risks

Check for things such as environmental sensitivity, the political climate, economic downturns

Price

Consider the appropriate amount of the investment

For income-producing residential property, which straight-line method would an investor use to calculate the property's annual depreciation allowance? Depreciable basis ÷ 25 years Depreciable basis ÷ 27.5 years Depreciable basis ÷ 39 years Depreciable basis ÷ 40 years

Depreciable basis ÷ 27.5 years For income-producing residential property, the investor would use the 27.5 year depreciation schedule

For income-producing commercial property, which straight-line method would an investor use to calculate the property's annual depreciation allowance? Depreciable basis ÷ 25 years Depreciable basis ÷ 39 years Depreciable basis ÷ 30.5 years Depreciable basis ÷ 40.5 years

Depreciable basis ÷ 39 years

John sells his single-family home and purchases a new home for his family to reside in. Marcus owns a single-family home, but rents it out to a co-worker while he is on an extended two-year military tour overseas. Donald sells an apartment complex and purchases a new complex in a different part of the city. Which of these consumers is most likely to take advantage of a 1031 tax-deferred exchange? John Donald Marcus John and Donald

Donald Remember, the investment must be held for investment or business purposes.

A property is on the market for $500,000. Ira, an investor, only considers investing in a property if it looks like he'll see a return of 10%. The estimated net annual income for this property is $30,000. Should Ira invest?

Dont invest; considering that the property has a net annual income of $30,000 and Ira's desire to warn a return of 10%, he should pay no more than $300,000

With regard to investment property, what are the two types of depreciation? Economic depreciation Sum of the years' depreciation Declining balance depreciation Tax depreciation

Economic and tax depreciation

Long-term capital gain Short-term capital gain Long-term capital loss Short-term capital loss

Increase in capital resulting from the sale of property owned more than one year Increase in capital resulting from the sale of property owned one year or less Decrease in capital resulting from the sale of property owned more than one year Decrease in capital resulting from the sale of property owned one year or less

Key Points

Investment analysis factors include price, financing, risks, rate of return vs. risk, and interplay of the variables. Debt coverage ratio is calculated by dividing NOI by annual debt service. Annual debt service is the total of all interest and principal paid for all loans on the property for one year. The debt coverage ratio is a benchmark used to determine an income-producing property's ability to cover its monthly debt service (e.g., mortgage payments).

Key points

Investors are concerned with before-tax cash flow, after-tax cash flow, sheltering cash from taxes, and cash-on-cash return. Investment goals include tax write-offs, long-term appreciation, and positive cash flow. To determine future value of a property take the current value and multiply it by the appreciation rate to get its value after one year. Multiply that value by the appreciation rate to get the value for the following year, and so on. Income-producing residential properties are depreciated on a 27.5-year schedule; commercial properties are depreciated over 39 years. The basis of an asset includes the sale price, acquisition costs, and any capital improvements. The IRS requires investors to depreciate their investment properties using a method called straight-line depreciation. Depreciation is limited to investment properties. You cannot depreciate residential, non-investment properties. Tax depreciation allows an annual business deduction by depreciating an asset. Economic depreciation occurs with a loss in value due to physical or other deterioration. Two types of depreciation impact investment properties: economic depreciation and tax depreciation. Allowable deductibles include depreciation, operating expenses, real estate taxes, and mortgage interest. Income shelters available to investors include tax losses investors can use to offset both passive and active income. Short-term gains apply to properties owned for one year or less. Long-term capital gain is an increase in capital resulting from the sale of an asset (such as property) owned for more than one year. The 180-calendar-day deadline to close on a subsequent property in a tax-deferred exchange is absolute. The 45-day deadline to identify a like-kind property in a tax-deferred exchange includes weekends. Cash an investor receives from sale proceeds is called "boot" and is taxable. Incoming-producing residential, commercial, and industrial properties, as well as hotels and motels, can qualify for an exchange. The 1031 tax exchange is used to defer paying taxes when there is an almost immediate repurchase of what's called a "like-kind" property. A tax-deferred exchange for properties used for investment or business purposes is also referred to as the like-kind or 1031 exchange.

Which of the following is true about investors and tax depreciation? Investors are not allowed to take a business deduction for annual depreciation. Investors can depreciate an appreciating asset. Depreciation is not limited to investment properties. Most investors try to avoid depreciation.

Investors can depreciate an appreciating asset. Depreciation of investment properties allows investors to depreciate an appreciating asset and use the depreciation as a business deduction; depreciation is limited to investment properties. Improvements can be depreciated; land itself can not.

What is a participation mortgage? It allows the lender to participate in the project by investing funds and realizing a return. It is a long-term estate for years pledged to the lender instead of the property. It uses the equity of one property to fund the purchase of another and is a common investment strategy. It allows the lender to increase the rate on the mortgage after the borrower pays off a specific percentage of the loan.

It allows the lender to participate in the project by investing funds and realizing a return.

Interplay of variables

Look at how a change in one variable can affect other variables

Financing

Look at whether money is available and at what rate

Long-term capital loss Short-term capital loss

Net loss may be deducted from taxable income to offset capital loss of longer than one year (one year + one day). Net loss may be deducted from taxable income to offset capital loss of one year or less.

What factors do you need to calculate appreciated value? Refer to the video or the transcript if you need assistance. Original value Appreciation rate Interest rate Net to seller

Original value Appreciation rate

What is a QI?

Qualified intermediary -- responsible for placing proceeds of the first sale with escrow, with instructions; handling the transactional paperwork with escrow; providing the transfer documents for the exchange; and submitting a 1099 to the taxpayer and the IRS for any gross proceeds paid out

What is the name of the method that investors use to calculate their annual property deduction? Economic depreciation Depreciable basis Straight-line depreciation Tax depreciation

Straight-line depreciation; investors use this method to calculate the depreciation allowance for income-producing properties

In investments, there are two types of depreciation and each is defined by a particular event. Which of the following most accurately pairs the depreciation type with the event it is tied to? Economic depreciation and cost recovery Tax depreciation and cost recovery Tax depreciation and physical deterioration Operating depreciation and taxing authority

Tax depreciation and cost recovery

Investors are looking for what:

Tax write-offs Long-term appreciation Positive cash flow Before-tax cash flow After-tax cash flow Sheltering cash from taxes Cash-on-cash return

Luther is analyzing an investment property. During his analysis, he looks at environmental sensitivity, political climate, the potential for a development moratorium, economic downturns, etc. What is Luther demonstrating? That real estate investments have too many risks That risks involved with real estate investments need to be analyzed That there are too many factors to consider when investing in real estate That financing is important

That risks involved with real estate investments need to be analyzed

Which of the following would be a description of economic depreciation? The asset is worth more because of capital improvements. The asset is worth less because it's deteriorating physically. The owner/investor is making less income from the property than previously. Investors can take a business deduction for annual depreciation.

The asset is worth less because it's deteriorating physically.

What is the 200% rule as it relates to tax-deferred exchanges? The combined fair market value of the property (or properties) being exchanged into cannot be more than 200% of the relinquished property. The capital gains realized from the property sale cannot be more than 200% of the original purchase price. The fair market value of the relinquished property must be 200% more than the property (or properties) being exchanged into. The capital gains realized from the property sale cannot be more than 200% of the sale price.

The combined fair market value of the property (or properties) being exchanged into cannot be more than 200% of the relinquished property.

When would an investor who is involved in a 1031 exchange consider entering into a 1031 reverse exchange? The investor decides to cancel the exchange before the end of the exchange period. The investor closes on the replacement property before selling the original property. The investor has sold the original property but can't identify a replacement property. The investor has completed the exchange but is not happy with the replacement property.

The investor closes on the replacement property before selling the original property. A reverse exchange is an option for an investor who has not sold the original property that is part of the 1031 exchange, but who has already purchased the replacement property to try and sell another property instead of the original property

You may think that the last thing an investor wants to see is a negative after-tax cash flow. However, there are some potential benefits. Which two of these are potential benefits of a negative after-tax cash flow? The loss could generate additional passive income. The loss could be used as a tax shelter. The loss could be used to offset other income.

The loss could be used as a tax shelter. The loss could be used to offset other income.

The Siegels are purchasing a commercial investment property and plan to use straight-line depreciation on their financial statements and tax calculations. Which of the following would NOT be included in the Siegel's depreciation basis calculations? The price that they paid for the property, minus any land costs The loan origination and lender fees that they paid at closing The prorated property taxes that they paid at closing The cost of the electrical system upgrades they did after purchase

The prorated property taxes that they paid at closing Depreciation basis is composed of the sales price plus any acquisition costs and capital improvements. The loan origination fee is an acquisition cost, and the electrical system upgrades are capital improvements.

Rate of return vs. risk

Weigh the risk of investing with the potential return

How you determine debt coverage ratio? You subtract income from expenses. You subtract expenses from income. You divide debt service by gross income. You divide net income by debt service.

You divide net income by debt service.

Jennifer is the owner of the single-family residence in which she resides. How long can she take to depreciate her property? Zero years (personal residences cannot be depreciated) 39 years Indefinitely 27.5 years

Zero years (personal residences cannot be depreciated) Depreciation is limited to investment properties—you can't depreciate a personal residence or vacation home.

95% rule

an investor can exchange multiple properties as long as the properties total at least 95% of the value of the relinquished property

3-Property Rule

an investor can identify up to three replacement properties with no fair market value restriction, provided they meet the debt load requirement

A property's sale price minus the adjusted basis is a ______. Rate of return Finance rate After-tax cash flow Capital gain

capital gain

After-tax cash flow

cash flow taking into account income taxes Formula: before-tax cash flow minus income taxes

Before-tax cash flow

cash flow without considering income taxes Formula: Net operating income minus expenses minus annual debt service

What is tax depreciation?

is when investors take an annual business deduction by depreciating an (often) appreciating asset

Cash-on-cash

ratio of annual before-tax cash flow to the amount of cash invested Formula: Before-tax cash flow divided by cash invested

200% Rule

when exchanging more than one property; the combined fair market value of the properties can't be more than 200% of the value of the relinquished property