# Private Real Estate Investment: Data Analysis and Decision Making_8

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## Private Real Estate Investment: Data Analysis and Decision Making_8

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2. 160 Private Real Estate Investment  The effect of tax deferral on risk  The cost of exchanging, not just the hard costs, but implicit costs often overlooked  The alternatives of sale and repurchase, refinance, or simply hold for a longer period Examples in this chapter build on earlier examples. In a complex world it is important to be able to isolate the most important variables on which investment decisions rest. As we move through the exchange strategy, we retain the burdensome minutiae that we labored over in earlier chapters. But as many of those calculations involve nothing new, having mastered them in earlier chapters, we now put them out of view. For instance, real estate is usually ﬁnanced with self-amortizing ﬁnancing. There is no reason to have the loan amortization calculation in the forefront of our present discussion. Exchange or no exchange, loans are a fact of life, and their amortization is not mysterious. The same can be said for depreciation, sale proceeds, and capital gain calculations. All of these are computed with fairly simple algebraic equations that need not be at center stage with the more important concept of the tax deferred exchange. VARIABLE DEFINITIONS The examples in this chapter are similar to those in Chapter 4 describing basic investment analysis.2 For pedagogical reasons we included a number of variables in Chapter 4 that are not needed here. For example, because operational variables prior to net operating income are mathematically trivial, they have been ignored here so that all examples in this chapter begin with net operating income (NOI). The list of variables used in this chapter has considerable overlap with that in Chapter 4 to which we add variables that permit growth rates to be different in different years. lc ¼ logistic constant when using the modified logistic growth function af ¼ acceleration factor when using the modified logistic growth function The electronic ﬁles that accompany this chapter provide a fully elaborated set of examples in Excel format. 2 The important difference is that in Chapter 4 value is a function of a market rate of growth. Here value is a function of both income growth and capitalization rate. The effect and importance of this difference is illustrated in the electronic files for this chapter.
3. 161 The Tax Deferred Exchange THE STRUCTURE EXAMPLES OF THE The examples illustrating the ideas in this chapter are organized as follows. 1. The Base Case: Purchase–Hold–Sell. An initial ‘‘base case’’ (base) is examined to provide background and context. In the base case the investor merely purchases, holds for six years, and sells a single property. During the holding period the value grows mono- tonically. 2. Example 1: Modifying the Growth Projection. Example 1 (dataEG1) deviates from the base case only by introducing the idea of growth at different rates over different time periods (the logistic growth idea discussed in Chapter 4) during the six-year holding period. 3. Example 2: The Tax Deferred Exchange Strategy. The second variation from the base case involves two properties (dataEG2a and dataEG2b) that are each held for three years in sequence. The second property is acquired via exchange of the first property. Thus, the ownership of the two properties spans the same time period as Example 1. Each property grows in value under the same conditions as those assumed for dataEG1. 4. The Sale-and-Repurchase Strategy: Tax Deferral as a Risk Modifier. The outcome of the exchange strategy is then contrasted with the results achieved via the taxable sale of the first property (dataEG2a) at the end of year three, the purchase of the second property (dataEG2c) with the after-tax proceeds of the sale of the first, and concluding with the taxable sale of the second property at the end of three more years (again a total of six). 5. The Sale-and-Better-Repurchase Strategy: The Cost of Exchanging. The sale-and-repurchase strategy portion of Example 2 is re-examined (dataEG2a and dataEG2d) using a lower price for the second purchase, presumed to be achieved with superior negotiation following the taxable sale of the first property. This addresses the question of how much price discount is needed upon acquisition of the second property to offset the value of tax deferral if exchanging is not an option. 6. Example 3: Exchanging and ‘‘the Plodder.’’ In the last variation (dataEG3a and dataEG3b) we repeat the same analysis as in Example 2, but return to the monotonic growth of the base case. We then compare the exchange outcome under those conditions with the sale and purchase alternative (dataEG3a and dataEG3c). Finally, we return to the base case assumptions to consider a longer term, 12-year buy-and- hold strategy of a single property.
4. 162 Private Real Estate Investment Each example and variation illustrates a different strength or weakness of holding, selling, exchanging, and/or reacquiring property. THE BASE CASE: PURCHASE–HOLD–SELL Data for our base case project is entered in Table 7-1, followed by the rules of thumb measures in Table 7-2. The ﬁnal year of the multi-year projection is shown in Table 7-3. For the terminal year reversion, we need calculations TABLE 7-1 Base Case Inputs .095 dp $360,000 i ⁄12 noi$119,925 initln $875,000 txrt 0.35 t 360 1 dprt ⁄27.5 r 0.13 land 0.3 k 6 cro 0.0936 scrt 0.075 g 0.03 cgrt 0.15 lc 0 recaprt 0.25 af 0 ppmt 0 units 22 TABLE 7-2 Rules of Thumb Capitalization rate 0.0971 Price per unit$56,136 Cash-on-cash return 0.0824 Debt coverage ratio 1.36 Loan-to-value ratio 0.7085 TABLE 7-3 Terminal Year Operating Performance Net operating income $139,025.94 Debt service$88,289.70 Depreciation $31,436.40 Income tax$9,785.96 After-tax cash ﬂow $40,950.30 5. 163 The Tax Deferred Exchange TABLE 7-4 Terminal Year Equity Reversion Sale price$1,474,655 Beginning loan balance $875,000 Ending loan balance$833,449 Original cost $1,235,000 Sale costs$110,599 Accumulated depreciation $188,618 Capital gain$317,674 Capital gains tax $66,513 Pre-tax net equity$530,607 After-tax net equity $464,094 TABLE 7-5 Base Case Net Present Value and Internal Rate of Return Base case NPV$557 IRR 0.130351 made at the time of sale, shown in Table 7-4. The npv and irr results for the base case are shown in Table 7-5. It is important to point out that the IRR in Table 7-5 is the after-tax IRR. Graphically, in Figure 7-1, we see the components of the sale proceeds in the base case. This sets the scene for the primary purpose of this chapter, which is to examine the ramiﬁcations of NOT having to pay capital gains tax. The Base Case represents a quite standard discounted cash ﬂow (DCF) analysis with monotonic growth over a ﬁxed holding period terminating in a taxable sale. Next, combining the modiﬁed logistic growth function described in Chapter 4 with the exchange strategy, we relax some of these assumptions. EXAMPLE 1—MODIFYING THE GROWTH PROJECTION First, we modify our data to reﬂect the entrepreneurial growth associated with an early transformation period. Note that in the base case data the variables for the logistic growth curve, lc and af, were zero. In Table 7-6 we see that in
6. 164 Private Real Estate Investment Allocation of Sales Proceeds $1,474,654 Loan Balance$833,448 ,5 sts 10 o 99 $1 le C Equity Reversion Sa x 12$464,094 Ta 6,5 CG $6 FIGURE 7-1 Allocation of final sales proceeds for the base case. TABLE 7-6 Input dataEG1 for Example 1 .095 dp$360,000 i ⁄12 noi $119,925 initln$875,000 txrt 0.35 t 360 1 dprt ⁄27.5 r 0.13 land 0.3 k 6 cro 0.0936 scrt 0.075 g 0.03 cgrt 0.15 lc 1.5 recaprt 0.25 af 2 ppmt 0 units 22
7. 165 The Tax Deferred Exchange TABLE 7-7 Six-Year After-Tax Cash Flow Comparison of Base Case with Example 1 Year Base case CF($) EG1 CF ($) 1 29,677 29,677 2 31,828 71,039 3 34,031 74,98 4 36,28 77,34 5 38,59 79,471 6 40,950 81,54 dataEG1 these variables take on real values. The ﬁrst year measures (rules of thumb) for this data are identical to the base case. The difference appears in the ‘‘out’’ years as seen in Table 7-7. There are considerable differences in terminal year outcomes (Table 7-8) arising from the meaningful difference in cash ﬂows over time (Table 7-7) due to the entrepreneurial effort applied. As usual, we are interested in the NPV and IRR measures under these changed conditions (see Table 7-9). They are, understandably, superior to the base case. As the IRR for Example 1 is so much above the required rate of return and the NPV is so large, one might argue that provided the required rate of return, r, was chosen appropriately for a ‘‘normal’’ real estate investment of TABLE 7-8 Terminal Year Comparison of Base Case with Example 1 Base ($) Data EG1 ($) Sale price 1,474,655 Sale price 2,074,789 Beginning loan balance 875,000 Beginning loan balance 875,000 Ending loan balance 833,449 Ending loan balance 833,449 Original cost 1,235,000 Original cost 1,235,000 Sale costs 110,599 Sale costs 155,609 Accumulated depreciation 188,618 Accumulated depreciation 188,618 Capital gain 317,674 Capital gain 872,798 Capital gains tax 66,513 Capital gains tax 149,781 Pre-tax net equity 530,607 Pre-tax net equity 1,085,731 After-tax net equity 464,094 After-tax net equity 935,949
8. 166 Private Real Estate Investment TABLE 7-9 Base Case and Example 1 IRR and NPV Comparisons Base NPV $557 DataEG1 NPV$353,158 Base IRR 0.130351 DataEGI IRR 0.298681 this type—independent of its need for renovation—the excess IRR or the entire NPV represents the return due the investor for his entrepreneurial efforts. Be that as it may, just changing the way value increases has considerably increased the productivity of this investment (and the productivity of the investor’s time). In Figure 7-2 we see that the total outcome and relative size of the components are, as expected, considerably different. Note that in both cases, at the time of sale meaningful investor capital goes to the government in the form of capital gains tax. There are two points to be made here. One, the obvious, is that an investor has a greater incentive to defer taxes the larger the tax liability he faces. More importantly, if one accepts the proposition that the excess IRR or the positive NPV represents a return on his time, the act of deferring the tax on that portion of the gain represents an act of deferring taxes on compensation for the investor’s efforts. The beneﬁt is analogous to that offered employees via corporate retirement and 401(k) plans. But in this case, the outcome is more directly inﬂuenced by the investor’s entrepreneurial management style. In the long run, this homegrown Allocation of Sales Proceeds Allocation of Sales Proceeds $2,074,788$1,474,654 Loan Balance Loan Balance $833,448$833,448 Sale C $15 osts 5,60 9 CG Tax$149,781 ts 2 os 9 ,51 e C ,59 66 l Equity Reversion Sa 110 x464,094 $Equity Reversion Ta$935,949 CG (a) (b) FIGURE 7-2 Allocation of sales proceeds for base case and Example 1.
9. 167 The Tax Deferred Exchange deferred compensation plan amounts to a pre-tax conversion of human capital into non-human capital. EXAMPLE 2—THE TAX DEFERRED EXCHANGE STRATEGY To examine this further, we look at the same investment period, six years, during which, rather than hold a single property, we acquire two properties in sequence. Each will be held three years, each require entrepreneurial effort, and each will undergo the early year rapid improvement in value due to those efforts. Thus, the entrepreneurial impact occurs twice, and the tax otherwise due on the gain attributable to entrepreneurial effort associated with the ﬁrst property will be deferred into the second property. We will keep many of the same assumptions regarding growth rates, income tax rates, expense ratios, and rules of thumb from the base case example. Thus, both properties in this example will be presumed to be acquired on the same economic terms, with the second property differing from the ﬁrst only in scale. The data for the ﬁrst property (dataEG2a) shown in Table 7-10 are the same as the data in Example 1, except for the shorter holding period resulting from a terminal year of 3. Hence, the acquisition standards for the ﬁrst property, as represented by the rules of thumb reﬂecting ﬁrst year performance, remain identical to those in Table 7-2. To make the comparison as fair as possible, for the second property we will again replicate the acquisition standards from the ﬁrst property. That is, we wish the ﬁrst year rule of thumb ratios in the second property to be the same as those for the ﬁrst property. The purpose of this is to hold constant a kind of risk standard, the assumption being that two properties with the same loan- to-value (LTV) ratio and debt coverage ratio (DCR) expose the investor to approximately the same risk. While not perfect, this approach is useful in a stylized example such as this for reasons that will become apparent later. To accomplish this we will ‘‘back in’’ to some of the values in the second property in order to hold ﬁrst year rule of thumb measures constant. One consequence of this is that some of the values may reﬂect unrealistic odd numbers, which in practice would likely be rounded to the nearest $1,000. The ability to sell a property and defer payment of income taxes is indeed cause to celebrate. But there is a price attached. Any gain not recognized for tax purposes on disposition cannot be included in the tax basis of the newly acquired property and thus is not eligible for depreciation. The practical effect of this is to transfer the basis from the old property to the new, an 10. 168 Private Real Estate Investment TABLE 7-10 Data Input dataEG2a for Example 2a .095 dp$360,000 i ⁄12 noi $119,925 initln$875,000 txrt 0.35 t 360 1 dprt ⁄27.5 r 0.13 land 0.3 k 3 cro 0.0936 scrt 0.075 g 0.03 cgrt 0.15 lc 1.5 recaprt 0.25 af 2 ppmt 0 units 22 accounting task known as an exchange basis adjustment. The exchange basis adjustment then determines the depreciation deduction available for the second property. Most of the accounting complexity in the exchange basis adjustment arises from partially tax deferred, delayed, or reverse exchanges. In the interest of simplicity, we will assume the exchange is concurrent and fully tax deferred. Qualifying for this is not difﬁcult. One need only acquire a property with at least as much equity and at least as much debt as the property disposed. Stated differently, except as may be necessary to pay transaction costs, one may not take any money out of the transaction (such money, known as ‘‘boot received’’ must be zero) and one must not be relieved of debt when the comparing debt on the new property to debt on the old (net mortgage relief must be zero). EXCHANGE VARIABLE DEFINITIONS Exchange variable deﬁnitions, having their primary inﬂuence on the exchange basis adjustment, are shown below. New loan ¼ new loan on acquired property Old loan ¼ loan on disposed property at time of disposition Mortgage relief ¼ mortgage relief in the exchange Total boot ¼ total boot received from the transaction Boot paid ¼ total boot paid into the transaction Acquired equity (new equity) ¼ equity in acquired property (forced to be equal to the pre-tax sales proceeds from the prior property)
11. 169 The Tax Deferred Exchange Net mortgage relief ¼ net mortgage relief after credit for boot paid Accumulated depreciation ¼ the accumulated depreciation taken on the first property during holding period one Indicated gain (potential gain) ¼ indicated if property is sold Recognized gain ¼ gain recognized for tax purposes New adjusted cost basis ¼ new adjusted cost basis in acquired property New land portion ¼ new land allocation of acquired property New building portion ¼ new building allocation of acquired property New annual depreciation ¼ new depreciation allowance on acquired property Some of the data for the exchange of tax basis into the second property comes from the pre-tax conclusion of holding the ﬁrst property, as shown in Table 7-11. The exchange of basis adjustment results in the new property having what is called a ‘‘carryover basis,’’ the complete computations for which may be found in the electronic ﬁles for this chapter. A summary of the values for this example is shown in Table 7-12. Note that the last item on the list is the annual depreciation deduction for the new property. This deduction is smaller than it would be if the same size property were purchased instead of acquired by exchange. This is a disadvantage of exchanging that must be overcome by some compensating beneﬁt. One of our tasks here is to explore and quantify that beneﬁt. Note that the pre-tax equity reversion for the ﬁrst property equals the equity acquired in the second property. The equity reversion for the ﬁrst TABLE 7-11 Data for Exchange of Tax Basis Potential gain $671,448 New equity$954,986 Original cost $1,235,000 Boot paid 0 Accumulated$94,309 Total boot 0 depreciation 1 Sale costs $146,930 Building depreciation rate ⁄27.5 Old loan$857,154 New land percent of property 0.3 New value $3,276,132 12. 170 Private Real Estate Investment TABLE 7-12 Carryover Basis for Second Property New loan$2,321,146 Mortgage relief 0 Net mortgage relief 0 Equity acquired $954,986 Value acquired$3,276,132 Indicated gain $671,448 Recognized gain 0 New adjusted cost basis$2,604,683 New land allocation $781,405 New building allocation$1,823,278 New annual depreciation $66,301 property is computed after the payment of mortgage balance and sales costs, but before payment of capital gain tax. Table 7-13 shows the input data for the two properties. Comparing the two, we see many similarities. In fact, the only differences are in the size of the property (in dollar value and number of units), the loan, the down payment, and the net income. We assume ratios, ﬁnancing conditions, tax rates, land allocations, and growth expectations are the same. We assume the properties are located in the same area, thus making somewhat realistic the fact that the acquisition standards of the second property are similar to those of the ﬁrst property. In any stylized example, one can ﬁnd contradictions. The price per unit for both properties at the time of the exchange transaction (disposition of the ﬁrst property and acquisition of the second property) has been forced to be approximately the same, but the capitalization rate for the acquired property is below the one sold (which means that cri2b < cro2a). An argument could be made for reversing these, but because any such argument would rely on the introduction of speciﬁc facts, such argument is no better than the one that can be made for the data as presented. Based on the above, the second property is acquired under the same general income/price conditions as the ﬁrst property. The rules of thumb for the two properties in Table 7-14 are the same except for price per unit (because the second property is acquired three years later) and after-tax cash on cash return (because of the reduced depreciation arising from the carryover basis). Important to our discussion later in this chapter, note that two risk variables, loan-to-value ratio and debt coverage ratio, are the same. The net effect is that, midway in our investor’s six-year real estate investment, he has sold a property, the value of which he had maximized, and 13. 171 The Tax Deferred Exchange TABLE 7-13 Example 2 Input Data for the First Property (dataEG2a) and the Second Property (dataEG2b) dataEG2a dataEG2b down payment 360000 down payment 954986 initial net operating income 119925 initial net operating income 318130 investor income tax rate 0.35 investor income tax rate 0.35 building depreciation rate 0.0363636 building depreciation rate 0.0363636 land percent of property 0.3 land percent of property 0.3 capitalization rate at sale 0.10048 capitalization rate at purchase 0.0971053 monotonic growth 0.03 monotonic growth 0.03 logistic constant 1.5 logistic constant 1.5 acceleration factor 2 acceleration factor 2 interest rate 0.00791667 interest rate 0.00791667 initial loan balance 875000 intial loan balance 2321146 total amortization period 360 total amortization period 360 investor required rate of return 0.13 investor required rate of return 0.13 terminal year 3 terminal year 3 selling cost rate 0.075 selling cost rate 0.075 capital gain rate 0.15 capital gain rate 0.15 recapture rate 0.25 recapture rate 0.25 prepayment penalty 0 prepayment penalty 0 number of units 22 number of units 37 TABLE 7-14 Rules of Thumb for Two Properties in the Exchange Sequence dataEG2a dataEG2b Capitalization rate 0.0971053 Capitalization rate 0.0971053 Price per unit$56,136.4 Price per unit $88,544.1 Cash-on-cash return 0.0824367 Cash-on-cash return 0.0761728 Debt coverage ratio 1.35831 Debt coverage ratio 1.35831 Loan-to-value ratio 0.708502 Loan-to-value ratio 0.708502 acquired a property to which he will apply the same entrepreneurial effort. It is meaningful that the transfer of his maximized equity to a property in need of his talent has been done without the payment of income taxes (something not easily accomplished when one invests in ﬁnancial assets). 14. 172 Private Real Estate Investment Allocation of Sales Proceeds 2,000,000 1,500,000 1,000,000$2,074,789 EG1 500,000 $5,196,898 EG2 LnBal SC CGT ER FIGURE 7-3 Sale proceeds comparison between Example 1 and Example 2. The ﬁnal step is to combine the performance of the two Example 2 properties (dataEG2a and dataEG2b) over a six-year holding period and to compare that outcome to Example 1 wherein a single property was held for six years. Although one can also illustrate intertemporal income and cash ﬂow, Figure 7-3 reﬂects only the results of selling the property at the end of six years. The exchange strategy, of course, yields a larger outcome. Using the exchange strategy, the NPV is$1,039,897 and the IRR is 46.205%. Both of these are calculated over the entire six years, including the cash ﬂows from both properties and the after-tax equity reversion from the second property. For simplicity, we assume the second property is disposed of in a taxable sale, although there is no reason one could not merely continue with another exchange. One may compute an IRR of 42.15% for the second property only using its cash ﬂows and after-tax sale reversion. But there is a problem with this in that the equity reversion for property two includes the payment of tax on capital gains deferred from property one. Thus the IRR for property two is calculated using a capital gain that arises, in part, from depreciation attributable to property one. But the calculation does not consider the associated beneﬁt of property one cash ﬂows. Thus, such an IRR solely for property two is not correct. To avoid this distortion, individual properties in a series of exchanges after the ﬁrst one should only be evaluated on a pre-tax basis for IRR and NPV purposes. The fact that after-tax IRRs should be only calculated on the cumulative and aggregate outcomes of all properties in a series underscores an important point. The decision to acquire investment realty is often a lifestyle decision. The investment is long term not only from the standpoint of how long one holds individual properties, but from the length of time measured by how long one holds a series of properties. In a way this introduces a different sort of ‘‘portfolio,’’ one that includes a number of properties held sequentially rather than at the same time. Investors who put all their eggs in one basket
15. 173 The Tax Deferred Exchange and watch (also change and improve) that basket move their eggs from basket to basket tax free and measure the results of their portfolios at the end of the last investment after the outcome of a sequence of property investments is known. There are ramiﬁcations for policymakers in emerging capitalist countries where income tax laws are being formulated. The early architects of the U.S. tax code believed it was important to the development of society to keep capital in the hands of private entrepreneurs. The decision to permit tax deferred exchanging in a society has repercussions on the development of that society’s built environment and long term investment. We mentioned at the beginning of this chapter that for some investors capital gain taxes may be completely eliminated. This happens if the sum of all holding periods exceeds the investor’s remaining life, because under present U.S. estate tax law capital gain taxes are forgiven at death. The practical result of this is that the estate tax effectively takes the place of the capital gains tax. As estate tax rates for large estates may be more than capital gain rates, care should be taken not to overuse the exchange strategy.3 THE VALUE TAX DEFERRAL OF An interesting empirical question arises over whether investors, seeking tax deferral, pay more for property they acquire via an exchange than they would have if they had merely purchased the property. Some investors view the deferral of taxes as ‘‘an interest free loan from the government.’’ This is questionable reasoning in that it assumes that investors have no money of their own, but are merely custodians of the government’s money. Regardless, the incentives are aligned to make tax deferral attractive, and investors are tempted to pay extra to get it. One needs to know the value of tax deferral. Using the tools in this chapter we can explore this value. The capital gains tax on the $671,448 potential gain shown in Table 7-11, should property one in Example 2 (dataEG2a) be sold, is$110,148. Given the three-year holding period of the ﬁrst property, one representation of the value of the tax deferral is nothing more than the value (present or otherwise) of the earnings on the taxes unpaid on the sale of property one that become due upon the sale of property two. A critical choice is the rate of return used to 3 As this is being written, the U.S. estate tax code is in a state of considerable uncertainty. The taxable portion of estates is dropping, and the entire tax is due to expire in several years and then a year later to be restored to the condition it was prior to the changes. No one can predict the destination of this very political matter, and current tax law should be consulted at the time plans are made.
16. 174 Private Real Estate Investment calculate those earnings. If we assume the IRR from these two properties is the investor’s average return, the nominal dollar value of tax deferral is simply Deferred Tax Ã ð1þIRRÞholding period of property two ÀDeferred Tax ð7-1Þ Knowing this, we may also be interested in how the value of tax deferral compares to the tax itself. Additionally, we could be interested in how the value of tax deferral compares to the purchase price of the property acquired.4 Using the 46.205% achieved IRR as the expected future rate of return and a holding period of three years, Table 7-15 shows that the value of the tax deferral is roughly twice the amount of the tax and about 7% of the value of the target acquisition property. These two measures give us some sense of scale as to how important the tax beneﬁts are in the big picture. The nominal dollar amount is considerable, but obviously sensitive to the compounding rate chosen. If a more modest return such as 15% is used, the value for the same holding period is, however measured, less, as seen in Table 7-16. This reduction may be overcome by increasing the holding period, as in Table 7-17. The graph in Figure 7-4 demonstrates the power of this strategy as the return to one’s entrepreneurial effort and/or holding period increases. Those with the ability to optimize opportunities, not surprisingly, beneﬁt more from tax deferral, but so do those who hold the property longer, even if the IRR is moderate. TABLE 7-15 The Value of Tax Deferral Value (IRR ¼ 0.46205, HP ¼ 3 years) $234,094 Value as a percent of capital gains tax due 2.125 Value as a percent of acquisition price of new property 0.0715 TABLE 7-16 The Value of Tax Deferral if Investment Return is Less Value (IRR ¼ 0.15, HP ¼ 3 years)$57,373 Value as a percent of capital gains tax due 0.520875 Value as a percent of acquisition price of new property 0.017513 4 Taking the present value of any of these measures is, of course, possible and would reduce them all. This introduces the additional complexity of deciding what discount rate to use, something we leave for the reader’s reflection and experimentation.
17. 175 The Tax Deferred Exchange TABLE 7-17 The Value of Tax Deferral if Investment Return is Less, but the Property is Held Over a Longer Holding Period Value (IRR ¼ 0.15, HP ¼ 8.15 years) $233,936 Value as a percent of capital gain tax due 2.12382 Value as a percent of acquisition price of new property 0.071406$2 Mil Value $1Mil 8 0 6 Holding 15% Period 4 25% Rate of Return 35% 2 FIGURE 7-4 Value of tax deferral as return and holding period changes. If one pays an additional ‘‘premium’’ to the seller to accommodate the exchange, several things happen. Most importantly, the value of the deferral is reduced because the price of the second property is higher. There are ancillary effects, some of which ease the pain of the higher price. The basis is higher, so the depreciation deduction is higher. Also, the gain on sale is less, thus capital gain taxes are less. Overpaying for the property does not necessarily entitle the buyer to market appreciation on the overpayment. So it is unreasonable to assume that nominal dollar growth will increase. Finally, paying a higher price involves either adding equity or debt, a decision that has its own set of ramiﬁcations. The net of these effects can never be positive, thus never recommends paying a higher price. The moral of the story is the same as it has always been: It always cheaper to pay taxes than lose money. One should not make busi- ness decisions based on tax consequences, even when those tax consequences are superﬁcially as compelling as deferring a large capital gains tax. 18. 176 Private Real Estate Investment THE SALE-AND-REPURCHASE STRATEGY: TAX DEFERRAL AS A RISK MODIFIER Next, let us investigate just what affect tax deferral has on the ﬁnal outcome as measured by the NPV and IRR. The way to approach this is ﬁrst to calculate the outcome if the ﬁrst property had been sold and a second property had been purchased with the after-tax proceeds of property one. We begin by recalling from the left side of Table 7-13 the data inputs that lead to the proﬁle and outcome of the ﬁrst property in Example 2, dataEG2a. The three-year operating history produces the annual cash ﬂow and reversion shown in Table 7-18. One consequence of the payment of capital gains tax is that the funds available for purchasing another property are less than they would have been if the ﬁrst property was exchanged. A decision must be made regarding the size of the second property. One may either (a) purchase a smaller property using the same proportion of debt; (b) purchase the same size property by adding cash from other sources in the amount of the cash paid in taxes; (c) incur additional debt to increase the size of the purchase; or (d) combine the foregoing alternatives in various ways. For the moment we will assume that leverage approximates risk, and if we wish to hold risk constant we will employ no more leverage in our sale-and-repurchase strategy than we would have if we exchanged. This assumption leads to determining the size of the second property purchased by the loan-to-value ratio (ltv). Some algebraic rearrangement of the basic real estate valuation identities will convince you that one can produce the net operating income from capitalization rate, ltv and down payment, three variables that may be derived from dataEG2a.   down payment Ã ltv noi ¼ capitalization rate down paymentþ ð7-2Þ 1 À ltv TABLE 7-18 Three-Year Summary of the First Property in Example 2 (dataEG2a) Year Cash ﬂow Reversion Total 1$29,677 — $29,677 2$71,039 — $71,039 3$74,986 $844,838$919,824
19. 177 The Tax Deferred Exchange A closer look at the last term in Equation (7-2) discloses that it is the initial loan balance expressed in terms of the ltv and down payment. down payment Ã ltv initial loan balance ¼ ð7-3Þ 1 À ltv We will assume, as we have before, that the second property is purchased in the same geographic area as the ﬁrst property and has a similar capitalization rate. We will initially assume that the second property is acquired with the same percentage of debt (ltv) as both the ﬁrst property and as the exchange property would have been. With these assumptions we begin to build a set of data inputs for a new second property to purchase. Recall the going-out capitalization rate for property one (dataEG2a in Table 7-13) was 0.10048. Using this capitalization rate, the after-tax equity reversion of property one as down payment, and the assumed debt ratio, net operating income for the second property becomes $291,216 and the initial loan is$2,053,425. Inserting this information into the dataset using equations dependent on ltv for the initial loan amount and net operating income, we have inputs for a second, this time purchased, property two (dataEG2c). Using a 70.8502% ltv, we can produce the value of all the inputs for purchased property two (see Table 7-19). Adding down payment to initial loan gives the value of the purchased property two of $2,898,262, which is$377,870 less than the $3,276,132 value of the exchange-acquired property two (dataEG2b). This$377,870 difference is, therefore, unavailable to grow under the owner’s entrepreneurial direction. Our interest is in learning how the absence of this capital affects the return after crediting back certain advantages of the purchase-and-sale strategy. TABLE 7-19 Data Input dataEG2c for Example 2c .095 dp $844,838 i ⁄12 noi$291,216 initln $2,053,425 txrt 0.35 t 360 1 dprt ⁄27.5 r 0.13 land 0.3 k 3 cro 0.103971 scrt 0.075 g 0.03 cgrt 0.15 lc 1.5 recaprt 0.25 af 2 ppmt 0 units 33 20. 178 Private Real Estate Investment TABLE 7-20 Exchange vs. Sale and Repurchase Exchange Sale and repurchase NPV$1,039,897 $957,920 IRR 0.46205 0.447485 One such advantage is the higher depreciation deduction. Table 7-20 shows a comparison of the results under the two strategies. Suppose we attempt to replicate the exchange NPV and IRR results in the sale-and-repurchase strategy by adding leverage. Some trial and error with the ltv argument leads us to an equivalent NPV if we borrow 73.93% rather than 70.85% of the purchase price. This demonstrates that tax deferred exchanging can be viewed as a risk modiﬁer. The NPV for the exchange strategy was achieved with less leverage than the NPV for the sale-and-repurchase strategy. Provided one accepts leverage as a measure of risk, the exchange strategy may be seen as involving less risk than the sale-and-repurchase strategy. Oddly, this result imparts some credibility to the ﬂawed ‘‘interest free loan from the government’’ idea. By exchanging the investor retains his capital in his investment free of tax. Therefore, he does not have to borrow the same funds from a lender to whom he would pay interest. THE SALE-AND-BETTER-REPURCHASE STRATEGY: THE COST OF EXCHANGING Earlier we said that one should never make business decisions based on tax consequences. This is a corollary of a broader truism: It is cheaper to pay taxes than lose money, something that is always true when tax rates are less than 100%. Recall above that, given a moderate IRR of 15% and a short holding period, the$57,373 value of tax deferral as a percentage of the acquired property from Table 7-16 was a rather modest 1.7513%. Suppose that tax deferred exchanges carry additional transaction costs. They do in a real sense in that specially qualiﬁed brokers, attorneys, tax accountants, and escrow holders are required, all of whom are aware of the tax beneﬁt and how their special skills make tax deferral possible. Suppose further that some aspect of the exchange inconveniences the seller of the target property in that he is exposed to additional complexity, risk the transaction does not close, and possible delays. Equally plausible is the fact that the seller is aware that the buyer will enjoy tax beneﬁts from the seller’s accommodation of the exchange process, for which he attempts to extract a premium price. All of these costs