INCOME TAXES ARE REALLY QUITE SIMPLE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
REAL AND UNREAL DEDUCTIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
MARGINAL INCOME TAX BRACKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
INVESTMENT REAL PROPERTY IN RELATION TO INCOME TAXES. . . . . . . . . . . . . . . . . . . . . . . . . .11
PASSIVE LOSS PHASE OUT FOR HIGH INCOME INVESTORS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
TYPES OF GAIN. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
PERSONAL RESIDENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
THE 1034 TAX DEFERRED EXCHANGE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
EVEN OR UP RULES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
SALE OF HOME IRS FORM 2119 CONSOLIDATED. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
$125,000 EXCLUSION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55
TYPES OF DEPRECIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
THERE ARE MANY TYPES OF DEPRECIATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58
PERSONAL RESIDENCE IN INCOME PRODUCING PROPERTY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
SALE OR EXCHANGE OF PRINCIPAL RESIDENCE, WORKSHEET. . . . . . . . . . . . . . . . . . . . . . . . . . . . .77
THE 1031 IRC TAX DEFERRED EXCHANGE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82
FINDING THE TAX BASIS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .86
ELEMENTS OF THE TAX DEFERRED EXCHANGE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
MORTGAGE RELIEF. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
EVEN OR UP RULES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
BOOT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
LIKE FOR LIKE RULES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
BALANCING OF THE 1031 EXCHANGE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106
INDEMNIFICATION AGREEMENT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
EXCHANGING WITH DISCOUNTED PAPER. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118
CONVERSION OF USE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
EXCHANGE WORKSHEET. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142
INSTALLMENT SALE "TAX DYNAMITE". . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
EXCHANGE, INSTALLMENT SALE COMBINATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162
THE DANGERS OF THE INSTALLMENT SALE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
BASIC TRUST DEED LAW. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
MORTGAGE & TRUST DEED COMPARED. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
THE EFFECTS OF BANKRUPTCY ON A TRUSTEE'S SALE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
SELLING OR HYPOTHECATING INSTALLMENT NOTES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176
INSTALLMENT SALE ANALYSIS SHEET. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
INCOME TAX BRACKETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
CALIFORNIA INCOME TAX BRACKETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178
FORECLOSURE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179
DEED IN LIEU OF FORECLOSURE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
TAX DEDUCTIONS FOR PARTIAL INTERESTS IN REAL PROPERTY. . . . . . . . . . . . . . . . . . . . . . . . . 186
PROBATE WE'LL ALL BE THERE SOMEDAY, OR WILL WE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .186
PROBATE ORDER AND TIMING OF EVENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
ESTATE FLOW CHART. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .194
TRUSTS TAKE THE GUESSWORK OUT OF DYING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195
IRREVOCABLE, REVOCABLE OR PARTIALLY REVOCABLE?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195
HAVE YOU BEEN ANNOYED BY LLOYD BOYD? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201
CHAPTER FOUR
INCOME TAXES ARE REALLY QUITE SIMPLE
Robert Rooks
February 2, 1995
There is a need for Real Estate Brokers/Salespersons to have a basic understanding of Income Taxes. We are placed in the middle as far as the law is concerned, in California the law simply says, we are supposed to know everything and advise on nothing we are not qualified to advise on, placing us in a position of "Finders of Problems", so that if there seems to be a legal problem we are supposed to advise the client to seek legal counsel, if there seems to be a tax problem, we are supposed advise the client to seek tax counsel. We are not allowed to give legal advice or tax advice unless we are properly credentialed. Still, we cannot neglect that the ownership of real property generates certain tax benefits, and tax liabilities at different periods in the ownership cycle. It should be helpful from a sales standpoint to be able to explain to a client the probable tax benefits that he/she should derive from the ownership of whatever kind of real property they are anticipating the ownership of. Most Tax Benefits and Tax Liabilities that are associated with the ownership of real property occur;
1. Upon Acquisition. 2. During Ownership. 3. Upon Disposition
a. Refinance. a. Divorce
b. Capital Improvements. b. Foreclosure
c. Casualty losses. c. Condemnation
d. Death
We want to understand income taxes so that we can save tax dollars for our clients, as well as ourselves. Income taxation is an area that the government and most accountants would just as soon you did not understand. The subject is inundated with strange sounding terms and verbiage, as well as, what will seem to be, mathematically questionable formulas, but this is a part of any profession or trade, when we want an understanding of something we have to learn the verbiage for clear communication, and consequently better understanding. Once you have a basic understanding everything starts becoming more and more simple.
$5,000 a Year Grows to $247,115 in 20 Years
If you were paying $5,000 a year in taxes and you could figure a way to save that $5,000 each year and you put the $5,000 into an 8% interest bearing bank account, you would have $270,419 in 20 years, providing you didn't have to pay taxes on the interest earned from the bank account, which of course you do. The really nice exclusion here is your I.R.A., or other qualified retirement accounts.
Most real estate investments show an average annual yield of 25% or more. That same $5,000 a year invested in real property would grow to $2,577,085 in 20 years at an annual yield of 25%. Your total investment would have been nothing because it would have been paid in taxes anyway, but if you count the actual dollars tax savings that you contributed over the 20 years, you would find that you had contributed $100,000. The $100,000 you would have paid in taxes before you learned how to save those tax dollars.
THERE ARE SEVERAL TYPES OF INCOME
There are several types of income, Passive Income, Portfolio Income, Active Income, Preferential Income, and Long Term Capital Gains Income. These have very little to do with us and how we react to saving tax dollars during our investment years. For the sake of understanding, for every type of income, there is a loss with the same name. We have Passive Losses, Portfolio Losses, Active Income Losses, and Long Term Capital Gain Losses. Today, at this writing we only have to be concerned with Passive, Active and Portfolio Income and Losses and how they may be intertwined.
Your taxable income really begins with gross income, and when the tax payer finally reduces this gross income figure by deducting allowed items he/she arrives at their taxable income. He/she then applies the appropriate tax rate to their taxable income and he/she comes up with the tentative tax. At this point, Tax Credits would be deducted, which gets you to what you actually owe. You would then add any self employment tax, or the minimum tax, whichever is greater, to determine the total tax that you owe.
While some of these terms can sound complicated they aren't really. It is just that they are new to your ears, and until you get used to the names it is difficult to understand. With a little effort on your part you will have a great enough understanding to figure the best position for your client and yourself when you are dealing with real property investments or homes. Finally, knowledge of taxation will ultimately lead to making more transactions work for you and for your clients.
SUMMARIZATION OF INCOME
First you want to find your total income, this is accomplished as follows;
Wages (Active Income) $
Interest Income $
Dividends (Stocks etc.) $
Capital Gains $
All Other Income $ .
This Brings you to Total Income $
Second you want to subtract your adjustments, IRA and Keogh Contributions;
Total Income $
Less Adjustments ($ )
This Brings you to Adjusted Gross Income $
From the Adjusted Gross Income you will subtract your itemized or standard deductions, and any personal exemptions you might have, this will bring you to your taxable income;
Adjusted Gross Income $
Less Itemized or Standard Deductions $
Less Personal Exemptions $
This brings you to Taxable Income $
At this point you would figure your taxes;
Taxes Due $
Less Credits ($ )
Plus Other Taxes $
Total Taxes Due $
DISPOSABLE, OR SPENDABLE INCOME IS THE REAL ISSUE
Your real concern should be how much disposable, or spendable, income you have after all of these deductions. There are real and unreal deductions, for example, the $5,000 you have extended for business deductions, are real, that is money that is really out of your pocket. If the expenses are well spent, they cause you to earn more money. If they are just spent without any real reward, additional business or absolute pleasure, the are ill spent and another area should be explored.
TAX DEDUCTIONS
Deductions are not returned 100%, only a portion of the actual dollars spent on the deduction are returned in the way of tax savings. If you spend $2,000 a year on lunches with clients, and you are in a 35% Marginal Income Tax Bracket, you would save $700 in taxes, or 35% of $2,000. This in effect means your actual luncheon activities would cost you, out of your own pocket, $1,300. If these lunches contributed $50,000 worth of income they would certainly be worth it. If on the other hand you bought a computer program for $2,000 and you never learned to use it, it never caused you to earn a dime, you would still save $700 over the long run, but you would have wasted $1,300 of your own money on something that is dysfunctional because of your disinterest. You should understand that deductions are not dollar for dollar, they do give you a tax break, but you pick up the lions share of the cost of the deduction. Therefore you want to make sure that the deduction is financially beneficial, or a heck of a lot of fun.
Generally the rule is this; IF YOU EXPEND MONEY FOR BUSINESS THE ITEM HAS TO EARN AT LEAST WHAT YOU PAID FOR IT, PLUS ANY TAXES DUE BECAUSE OF THE INCOME EARNED BY THAT ITEM. THEN THE ITEM WOULD HAVE PAID FOR ITSELF. THEN YOUR ONLY PROBLEM IS THE TIME PERIOD IT TAKES FOR THE EXPENDITURE TO RETURN THE INVESTED CAPITAL - HOW LONG BEFORE YOU GET YOUR MONEY BACK, HOW LONG BEFORE YOUR INVESTED MONEY IS RETURNED, OR MAKES A PROFIT, AND FINALLY HOW MUCH TIME YOU SPEND TRYING TO MAKE THE INVESTMENT FUNCTIONAL?
CREDITS COMPARED TO DEDUCTIONS
You can see from the previous discussion that the deduction reduces the "Taxable Income", it is money spent, prudently we hope, and you would deduct it from your Gross Earnings and finally come up with your "Taxable Income" pay taxes on that instead of paying taxes on your Gross Income. With a deduction, you pay for part and the government pays for part.
A Tax Credit is deducted from the taxes that you are to pay. Tax Credits are dollar for dollar. For example, if you have a $5,000 dollar Tax Credit, you figure your taxes out, and you owe $15,000 in taxes, you would deduct the credit and owe $10,000 in taxes. The government picks up the whole tab.
There are deductions that are real, and deductions that are unreal. For example in our previous deduction of $5,000, we actually had to pay that out, we paid $5,000 and we got a $5,000 deduction. That would cause us, in the highest income tax brackets, 39.6% Federal and 11% State, to have a Marginal Bracket of 50.6%, or we would save 50.6% of $5,000 our tax savings would be $2,530. We would still have to pay the difference, or in this case $5,000 – $2,530 = $2,470. For most of us, it would be more realistic to figure these problems using a 30% Combined Marginal Tax Bracket. With unreal deductions, such as the depreciation we are entitled to take on an income producing property, we are privileged to take a deduction without actually having to pay anything for it. This is a beautiful benefit in the ownership of income producing real estate. While the property is usually going up in value, we get to pretend it is going down in value for income tax purposes.
IN THE CASE OF AUTOMOBILES AS DEDUCTIONS
In the case of automobiles used for business we are allowed to deduct 28¢ per mile, not to exceed 60,000 miles, or 5 years. If you use MACRS (Modified Accelerated Cost Recovery System) You adjust the value of the car by 80% and then apply the MACRS tables. You are further restricted by more expensive automobiles, the upper limit of the cars value is supposed to be $12,800, which isn't worth going into in this writing. Still, you have to have a car, so any little bit helps. If you use MACRS or ACRS for luxury cars you are restricted to the amount of annual depreciation as follows;
Year I Year II Year III Year IV Year V
$2,660 $4,200 $2,550 $1,475 $1,475
Full Allowance X 80% Business Use = Deduction
The Full Allowance is;
$2,128 $3,360 $2,040 $1,180 $1,180
In the case of the automobile, if we are in a combined Federal and State Marginal Income Tax Bracket of 50.6% we would save 50.6% of the allowable deduction as above, or;
Year I Year II Year III Year IV Year V
$1,051 $2,075 $1,008 $ 583 $ 583
Further, you can deduct 80% of all of your gas bills, repair bills and maintenance bills. What this really amounts to, is that you can use one of two methods the 28¢ a mile, or the depreciation and maintenance, gas repair method. It would seem obvious that the second method is more profitable for you. If in our example we drive 12,000 miles a year and we multiply that by 28¢ we come up with $3,360 a year as an automobile deduction, this would amount to $1,700 in annual tax savings assuming a 50.6% Marginal Bracket.
If on the other hand, you spend $2,500 a year in repairs and maintenance, and your car gets 20 miles to the gallon, you would have used 600 gallons of gasoline assuming this 12,000 annual mileage, and further assuming that gasoline cost you $1.35 a gallon, you would have the following year one;
Gasoline Deduction = $ 810 X 80% = $ 648 Deduction
Repair & Maintenance = $2,500 X 80% = $2,000 Deduction
Year One Car Deduction = $ 843 X 00% = $ 843 Deduction
Total Deduction Year One = $3,491
You can see using MACRS you will come out a little further ahead in year two, in year 3 you will have less and year 4 & 5 will find you with the lowest deduction. Using Method One, you would simply have 12,000 Miles X 28¢ = $3,360 Annually, times 5 years ='s $16,800. Method Two may be an advantage for you, you will have to keep detailed receipts when using this method.
Anyone who has any income at all, income that is subject to taxes, is in what we call a Marginal Income Tax Bracket. Marginal Income Tax Brackets are stated as a percentage. For Example; if you are in a 35% marginal income tax bracket, this simply means that the next dollar that you earn will be taxable to the extent of 35%, or 35¢ will be paid in taxes, conversely, if you have one dollar in deductions and you are in a 35% Marginal Income Tax Bracket, you will save 35¢.
Marginal Tax Bracket Percentages are handy tools for estimating, quickly, how much you will save, or how much you will have to pay. There is a built in inaccuracy when you are dealing with larger amounts of income, because as you deduct more and more you are moving into a lower Marginal Income Tax Bracket, and as you are earning more and more you are moving into a higher Marginal Income Tax Bracket.
You have to learn to work with the tables, remember that most real estate investors have incomes of between $40,000 and $80,000 a year. Let's look at the Federal Marginal Tax Bracket for a married couple filing jointly, who have an Adjusted Gross Income of $80,000.
FEDERAL
MARGINAL TAX BRACKET
MARRIED FILING JOINTLY 1993
In the case of Federal, or State Marginal Brackets you are concerned with the percentage of the next dollars earned or the next dollar in loss. Let's suppose that our couple had an adjusted gross income (AGI) of $80,001, what will the taxes be? (A complete set of 1993 Tax Tables are locate on page 178 of this text)
Income X Bracket = Taxes Due
$ -0- to $ 36,900 X 15% = $ 5,535
$ 36,901 to $ 89,150 X 28% = $14,630
$ 89,151* to $140,000 X 31% = $15,763
$140,001 to $250,000 X 36% = $39,560
More than $250,000 X 39.6% = $ ???
When your adjusted gross income is $89,150 you are in a 28% Federal Marginal Tax Bracket, the minute you earn $89,151 you are in a 31% Federal Marginal Tax Bracket.
Federal Taxes On $89,150 = $20,165.00
Federal Taxes On $89,151 = $20,165.31
Differences $ 1 = $ .31
Taxes Paid $0.31
Dollars Earned = $1.00 = 31% Federal Marginal Tax Bracket
This would mean that if you had an adjusted income of $89,151 you would be in a 31% Federal Tax Bracket which would make your Marginal Tax Bracket 31%
What about one dollar less?
In the case of Federal, or State Marginal Brackets you are concerned with the percentage of the next dollars earned or the next dollar in loss. Let's suppose that our couple had an adjusted gross income (AGI) of $79,999, what will the taxes be?
Income X Bracket = Taxes Due
$36,900 X 15% = $ 5,535.00
$52,250 X 28% = $14,630.00
Taxable Income $89,150 Total Federal Taxes Due $20,165.00
It is apparent that one dollar less saved us 31¢ in taxes, or in other words;
Federal Taxes On $89,151 = $20,165.31
Federal Taxes On ($89,150) = ($20,165.00)
Differences ($ 1) = ($ .31)
That is simple enough to figure, but we have to be concerned with California Taxes too. When we figure the brackets on California Taxes we can actually come up with a Combined Federal & State Marginal Income Tax Bracket for any client. State tax tables are a bit different.
We will assume, through this writing, that our couple is making $80,000 per year, this will keep them in a 28% Federal Marginal Tax Bracket, except when they sell property, which will put them in the higher income tax brackets.
CALIFORNIA INCOME TAX BRACKETS 1993
(A complete set of 1993 Tax Tables is located at page 178 of this text)
If Taxable Income Is Computed Tax Is Taxable Income
At Least but Not Over Times Less
$ 0 $ 9,322 0.010 $ 0.00
$ 9,333 $ 22,118 0.020 $ 93.32
$ 22,119 $ 34,906 0.040 $ 535.68
$ 34,907 $ 48,456 0.060 $ 1,233.80
$ 45,457 $ 61,240 0.080 $ 2,202.92
$ 61,241 $212,380 0.093 $ 2,999.04
$212,381 $424,760 0.100 $ 4,485.70
$424,761 — 0.110 $ 8,733.30
These State of California Computations are a little different than the Federal, you have to figure the tax and then deduct the taxes that would have been paid on the lesser amounts. It is a graduated scale, but it graduates more rapidly than the Federal Tax Charts.
To figure our client with an adjusted gross income (AGI) of $80,000, we would simply multiply $80,000 by 9.3% and subtract $2,999.04, this would give us the taxes due on the $80,000. Then to figure their marginal tax bracket we would divide the taxes paid by the Taxable Income, this will give us a State of California Marginal Tax Bracket. If we then combine the Federal Marginal Tax Bracket with the State Marginal Tax Bracket we should come up with a Combined Marginal Tax Bracket that multiplied against the Taxable Income will give us the total taxes due for the State and the Fed. Let's try it;
STATE OF CALIFORNIA TAXES DUE
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$80,000 X 0.093 – $2,999.04 = $4,440.96
FIGURE STATE MARGINAL TAX BRACKET
Suppose in this example our taxpayer had an adjusted gross income (AGI) of $80,001, what would be the State Marginal Tax Bracket?
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$80,001 X 0.093 – $2,999.04 = $4,441.05
You quickly see that $1.00 less, or $1.00 more costs or saves us 9¢ in taxes, or in other words;
State Taxes On $80,001 = $ 4,441.05
State Taxes On $80,000 = $ 4,440.96
Differences ($ 1) = ($ .09)
Taxes Paid $0.09
Dollars Earned = $1.00 = 9%
In this example, our Federal Marginal Bracket is 28% and our State Marginal Bracket is 9%, this adds up to a Combined Marginal Income Tax Bracket of 37%. Our Federal Tax Bill would be $17,603 and our State Tax Bill is $4,440.96, if we add these two together, we come up with $22,043.96 for a total State of California and Federal Tax Bill.
FIGURE COMBINED MARGINAL TAX BRACKET
Sooner or later you will fall into this trap. You never take the total taxes paid against the Taxable Income, this is an average tax paid, not a Marginal Tax Bracket.
Taxes $22,043.96
Taxable Income = $80,000.00 = 27.55% Average Taxes Paid
Once you have figured the Marginal Tax Brackets, you can come up with a Combined, State & Federal, Marginal Tax Bracket by simply adding the two together, and check for accuracy to make certain you don't make the common mistake of using an Average Tax Paid.
FINDING THE COMBINED MARGINAL TAX BRACKET
Federal Marginal Bracket + State Marginal Bracket = Combined Marginal Bracket
28% + 9.3% = 37.3%
Check This For Accuracy Against Your Proven Combined Marginal Tax Savings
$1 of Additional Income or Loss X 37.3% = 37.3¢ or (37¢)
The next dollar earned, or the next dollar in write-off will either cost you or save you 37¢
These Marginal Brackets work well for small amounts of additional Taxable Income, or small amounts of additional write-off. When you have large gains, or large loses, the marginal brackets won't work accurately. The saving grace is that we are usually working on write-off and the Marginal Bracket selected will usually give an erroneously low tax savings. With large gains, the error is in the other direction in most cases, the estimated taxes will be low.
For example, with our couple with a taxable income of $80,000, what if we were able to generate a $20,000 deduction or loss. We already know that they are in a Combined Marginal Income Tax Bracket of 37%. If we then quoted this additional $20,000 deduction or loss as savings them $7,400 in taxes we would be very close to the actual tax savings.
Loss or Deduction X 37% = Tax Savings
$20,000 X 37% = $7,400
WHAT IS THE REAL TAX SAVINGS FROM THIS $20,000 DEDUCTION?
FORMER TAXABLE INCOME = $80,000
DEDUCTION OR LOSS = ($20,000)
NEW TAXABLE INCOME
OR LOSS AFTER DEDUCTIONS = $60,000
From our tax tables we would come up with the actual new Income Tax as follows;
FEDERAL TAXES ON $60,000
TAXABLE INCOME TIMES RATE = TAXES DUE
$36,900 15% = $ 5,535.00
$27,550 28% = $ 6,468.00
Total $60,000 = $12,003.00
CALIFORNIA STATE TAXES ON $60,000
Taxable Income Times Rate Less Adjustment Equals Taxes
$60,000 X 0.080 – $2,202.92 $2,597.08
TOTAL TAX SAVINGS ON $20,000 DEDUCTION OR LOSS
FORMER TAX ON $80,000 TAXABLE INCOME = $22,043.96
NEW TAX BECAUSE OF $20,000 DEDUCTION OR LOSS = $14,600.08
ACTUAL TAX SAVINGS ON $20,000 DEDUCTION OR LOSS = $ 7,443.88
$20,000 X 37% = $ 7,400.00
This is an example of how well the marginal brackets can work, you have to use caution, as large amounts of write-off can place you in a much lower marginal bracket, and your calculations will be to high.
WATCH WHAT HAPPENS TO
MARGINAL BRACKETS WHEN TAXABLE INCOME INCREASES
What if our couple had an additional $20,000 in Taxable Income? How would our Marginal Brackets work then?
WHAT ARE THE TAXES ON THIS ADDITIONAL $20,000 OF INCOME
Former Taxable Income $ 80,000
Additional Taxable Income $ 20,000
NEW TAXABLE INCOME $100,000
FEDERAL TAXES ON $100,000
TAXABLE INCOME TIMES RATE = TAXES DUE
$ 36,900 15% = $ 5,535.00
$ 52,250 28% = $14,630.00
$ 10,850 31% = $ 3,363.50
Total $100,000 = $23,528.50
Our old Federal Marginal Tax Bracket 28% would give us an erroneous error, because of the tax creep or jump at $89,150 still, let's try using the Marginal Bracket to check for accuracy;
$100,000 X 28% = $28,000
This gives us an error of $4,471.50. Marginal Brackets are handy, but they have to be adjusted from time to time. Here, a more accurate Federal Marginal Tax Bracket would be 23.53%.
STATE INCOME TAX ON $20,000 ADDITIONAL TAXABLE INCOME
Taxable Income Times Rate Less Adjustment Equals Taxes
$100,000 0.093 $2,999.04 $6,300.96
Our old State Tax on the $80,000 was $4,440.96, the difference between our old tax and the new tax of $6,300.96 is $1,860 and dividing that by $20,000 will give you exactly 9.3%, which was our State Marginal Tax Bracket.
TOTAL STATE AND FEDERAL INCOME TAXES ON ADDITIONAL $20,000
Total Taxes on $80,000 Total Taxes on $100,000
Federal Taxes $17,603.00 $23,528.50 = $ 5,925.50
State Taxes $ 4,440.96 $ 6,300.96 = $ 1,860
Totals $22,043.96 $29,829.46 = $ 7,785.50
COMBINED, STATE & FEDERAL, MARGINAL INCOME TAX BRACKET
Taxes $ 7,785.50
Taxable Income = $20,000.00 = 38.93%
In this example we find that we are using an acceptable Combined Marginal Tax Bracket, of 37.3%, on the additional taxable income and it is coming out a little low. These marginal brackets will be accurate if we are correct in our calculations of them. The are not exact. When we are looking at deductions, we are normally moving downward in the tax brackets, where most tax bracket changes occur, both state and federal, so the errors will grow, but in the proper direction, downward, so we are telling a client they will have to pay more, when in fact they will be paying less.
WHY DO WE USE MARGINAL INCOME TAX BRACKETS?
The reason Brokers/Salespersons, CPA's and Tax Preparers use Marginal Income Tax Brackets to estimate savings or taxes due is because from year to year we don't actually know what their tax situation will be. As Brokers, we don't normally know the persons tax picture at all and it is the one safe tool that will help the client understand what he/she can expect the investment to save them in taxes. CPA's and Tax Preparers use Marginal Brackets based on the last tax filing, still not knowing just what that taxpayers tax picture is for that year. Finally, Marginal Brackets are handy tools when you are selling real estate and the question comes up, "Just what will I save in Taxes this year."
INVESTMENT REAL PROPERTY IN RELATION TO INCOME TAXES
Real Property Held for investment, Income Property, creates certain tax advantages that ultimately lead to tax savings. The maximum tax advantage from income producing property against your Active, or Ordinary Income is limited to $25,000 annually. There is still another hook, if your Adjusted Gross Income is over $100,000 you will get less and less of the deduction against your Active Income. Income property is privy to Passive Income and Passive Loss Rules, so that if you had other property that was passive, and it produced income you would have no restrictions against using the passive loss from one building against the passive gain from another.
PASSIVE LOSS PHASE OUT FOR HIGH INCOME INVESTORS
As a taxpayers Adjusted Gross Income passes the $100,000 mark, they gradually lose any Passive losses against Active Income. This occurs gradually as the Adjusted Gross Income moves in an upward direction from $100,000. You don't lose the write off, you simply aren't allowed to take it at this time, this has the effect of keeping the Adjusted Tax Basis at a higher value, because it is not being used or depleted through depreciation. You can calculate it as a percentage, something like this;
ADJUSTED PASSIVE LOSS ALLOWED
GROSS INCOME FROM REAL ESTATE PERCENTAGE
$100,000 $25,000 = 100%
$105,000 $22,500 = 90%
$110,000 $20,000 = 80%
$115,000 $17,500 = 70%
$120,000 $15,000 = 60%
$125,000 $12,500 = 50%
$130,000 $10,000 = 40%
$135,000 $ 7,500 = 30%
$140,000 $ 5,000 = 20%
$145,000 $ 2,500 = 10%
$150,000 $ -0- = 0%
Remember, the write off is not really lost, it is not deductible against the Active Income, and when the building is finally sold, the Adjusted Tax Basis will be higher than it would have been had the Passive Loss been allowed.
OUR COUPLE BUYS A FOUR-PLEX
Let's look at our couple with the $80,000 Adjusted Gross Income. What if they had an apartment building that created some deductions for them, let's look at what would happen if they purchased a four-plex, Costing $400,000, with $80,000 Down and a new 1st Trust Deed of $320,000, an Adjustable Rate Mortgage, 2.25% over the 11th District Monthly Cost of Funds Index, and a start rate of 8.75% for the first 6 months, the second 6 months are calculated at 10%. then we will assume that the interest rate and payments stay at 10% for 348 periods, the duration of this investment. The building consists of one (1) 3 Bedroom, 2 Bath unit that is renting for $1,000 a month, there are three (3) 2 Bedroom, 2 Bath units renting for $850 a month. The improvement will be deducted at 70% of the purchase price, and since it is a residential income property (Apartments) we will use 27½ year straight line depreciation. (Remember if it is a commercial building, you would use 31½ Straight Line Depreciation). The vacancy factor on this building comes to 2% annually, and the expenses of operation are 20% annually. Let's look at what we have in the way of cash flow. First, a picture of our loan.
YEAR INTEREST PRINCIPAL LOAN BALANCE
1. $29,352.49 $ 856.79 $319,731.81
2. $31,884.31 $1,974.41 $317,757.40
3. $31,677.57 $2,181.15 $315,576.25
4. $31,449.16 $2,409.56 $313,166.69
5. $31,198.85 $2,661.87 $310,508.82
6. $30,918.12 $2,940.60 $307,564.22
CASH FLOW PICTURE – FOUR-PLEX YEAR ONE
Gross Scheduled Income $42,600
Vacancy Factor 2% ($ 852)
Gross Operating Income $41,748
Expenses of Operation 20% ($ 8,520)
Net Operating Income $33,228
New 1st Trust Deed ($30,209) = $320,000
Cash Flow Year One $ 3,019
Total Loans - - - - - - - - - - - - - - - $320,000
Cash Down Payment - - - - - - - - - - - - - $ 80,000
Purchase Price of Building - - - - - - - - - - - $400,000
FIGURE ANNUAL DEPRECIATION
Building Improvement
Value X Percentage = Depreciable Amount, or Value of Improvements, or;
$400,000 X 70% = $280,000 Depreciable Amount of Improvement
Depreciable Amount
Depreciable Years = Annual Depreciation or;
$280,000
27½ Years = $10,182 Annual Depreciation
TAX PICTURE FOUR- PLEX, YEAR ONE
Gross Scheduled Income $42,600
Less Vacancy Factor ($ 852)
Less Expenses of Operation ($ 8,520)
Less Interest Expense of 1st Trust Deed ($29,353)
Less Depreciation ($10,182)
Total Deductions ($48,907) ($48,907)
Net Tax Loss or Gain - - - - - - - - - - - - - - - ($ 6,307)
Regardless of the fact that the building has a positive cash flow in the amount of $3,109 this first year, it has also generated a Tax Loss of $6,307. Let's look at the net effect this has on our couples $80,000 Taxable Income.
FEDERAL INCOME TAXES WOULD BE FIGURED ON $80,000 – $6,307 = $73,693
Income X Bracket = Taxes Due
$36,900 X 15% = $ 5,535
$36,793 X 28% = $10,302
Taxable Income $73,693 Total Federal Taxes Due = $15,837
You will remember that the old Federal Tax Bill was $17,603 and the new bill is $15,837, so for Federal Taxes the couple has saved $1,766. Your Marginal Bracket of 28% as we figured out before would be multiplied against the $6,307 in write-off generated by the building, and you would come up with $1,766. This is right on the money, which should make you look like a hero. Here, we can safely assume that using a 28% Marginal Tax Rate for Federal Taxes would be safe.
STATE INCOME TAXES WOULD BE FIGURED ON $80,000 – $4,863 = $75,137
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$73,693 X 0.093 – $2,999.04 = $3,854.41
The old State Tax Bill was $4,440.96 and the new is $3,854.41, so we have a tax savings here of $586.55. If we apply our old Marginal Stat Tax Rate of 9.3% against the $6,307 in write off, we will come up with a tax savings of $586.55 which again makes us look pretty darned smart. Here we can conclude that 0.093% is a safe State Marginal Tax Bracket, further, we can combine the two and come up with a COMBINED STATE AND FEDERAL MARGINAL TAX BRACKET OF 37.3%. Now we want to know what our total tax savings due to Federal & State Tax Savings is, plus our cash flow? This is called After Tax Cash Flow, or ATCF.
TOTAL TAX SAVINGS AND CASH FLOW YEAR ONE
Federal Tax Savings $1,766
State Tax Savings $ 587 = $2,353 Total Tax Savings
Cash Flow From Building $3,019
Total Savings $5,372
This simply means that because this couple bought this building, they have an additional, after tax cash of $5,372 for the first year of ownership. This cash flow and tax savings alone represents a 6.72% return on their investment of $80,000.
LET'S LOOK AT OUR COUPLES REAL WORLD
The real world for our couple,(how much they really earned and what some of the other deduction are) would be computed, roughly, as follows;
SUMMARIZATION OF INCOME
First you want to find your total income, this is accomplished as follows;
Wages (Active Income) $111,450
Interest Income $ 2,000
Dividends (Stocks etc.) $ 0
Capital Gains $ 0
All Other Income $ 0
This Brings you to Total Income $113,450
Second you want to subtract your adjustments, IRA and Keogh Contributions;
Total Income $113,450
Less Adjustments ($ 4,000) = IRA ACCOUNTS
This Brings you to Adjusted Gross Income $109,450
From the Adjusted Gross Income you will subtract your itemized or standard deductions, and any personal exemptions you might have, this will bring you to your taxable income;
Adjusted Gross Income $109,450
Less Itemized or Standard Deductions $ 23,250
Less Personal Exemptions $ 6,200
This brings you to Taxable Income $ 80,000
At this point you would figure your taxes;
Taxes Due $ 17,603
Less Credits ($ 0 )
Plus Other Taxes $ 0
Total Taxes Due $ 17,603
This only brings us to the taxable income, what we really want to know is what their after tax spendable income will be. When we find the after tax spendable income we can really figure just what this building will do for them. We will consider the IRA (Individual Retirement Accounts) Contributions as spendable income because they still have it.
AFTER TAX SPENDABLE INCOME WITHOUT THE BUILDING
TOTAL INCOME $111,450
LESS TAXES WITHOUT BUILDING ($ 22,044)
AFTER TAX OR SPENDABLE INCOME $ 89,406
AFTER TAX CASH FLOW WITH BUILDING YEAR I
TOTAL INCOME $111,450
CASH FLOW FROM BUILDING $ 3,019
NEW TAXES WITH BUILDING ($ 19,691)
AFTER TAX SPENDABLE INCOME $ 94,778
INCREASED SPENDABLE INCOME OWNING THE BUILDING, YEAR I
NEW AFTER TAX SPENDABLE INCOME $94,778
OLD AFTER TAX SPENDABLE INCOME ($89,406)
INCREASED SPENDABLE CASH $ 5,372
TOTAL RETURNS ON THE BUILDING YEAR ONE
You can generally assume that rents will increase a certain percentage annually, but over a period of years, 5 or 10. In Southern California many investment broker/salespersons use the assumption that rents will increase an average of 8% annually. This really means that you may not be able to increase the rents at all one year, but you may be able to increase them 15% another year. This will have the propensity to cause the building to increase in value for many reasons. Assuming that your vacancy factor, expenses and loan payments stay the same and your rents increase you can conclude that your cash flow will increase and that the buildings value will increase. Further, you'll discover that if your rents are raised that your tax savings will decrease.
When we measure the total return on a building we assume certain value increases, and though they may not take place in a given year, another year will show astounding advances so that we can assume a certain appreciation rate for the building. When we measure the returns on any building, we measure them in four distinct areas, and a fifth rather innocuous area. The five areas are;
Cash Flow + Tax Savings + Appreciation + Equity Build–Up (Loan Paydown) + Inflationary Hedge
Assuming the building increases in value an average of 8% annually, this first year our real returns will be as follows;
TOTAL RETURNS ARE USUALLY SHOWN LIKE THIS
Cash Flow Year I $ 3,019
Tax Savings $ 2,353
Equity Build Up $ 268
Appreciation $32,000
Total Returns Year I $37,640
Total Return $37,640
Cash Down Payment = $80,000 = 47.05% ☺
REAL ESTATE AS AN INFLATIONARY HEDGE
Our fifth more innocuous area is inflationary hedge. In this writing, we won't show inflationary hedge as a calculated benefit of the ownership of real property, it is well worth having an understanding of the effects of inflation. If we are involved in a period of inflation, and you have money in an asset that keeps pace with inflation, your "Buying Power" will be preserved. For example, lets look at $100,000 in an interest bearing bank account earning 5% annually, further, we will assume that inflation is 3% annually. Here is the bank account before any effects from inflation.
Bank Balance X Interest Rate = Year End Bank Balance
$100,000 X 5% = $105,000
So, at the end of the year you have $5,000 that you have earned on your $100,000. Nice. If inflation is moving at 3%, it has the effect of devaluating the dollar by the reciprocal of 1.03, thus;
Inflation at 3% = 1 = 0.97 or 97%
1.03
You would then multiply your total bank account by 97%, and you would come up with the buying power of that money at the end of the year; or,
$105,000 X 97% = $101,850
The buying power of your money has diminished to $101,850, still, it isn't so bad, you have more buying power at the end of the year than you had at the beginning of the year. Your after inflation earnings are 1.85% a year. But is that true?
What about taxes, the interest earned would be subject to income taxes unless it were a tax exempt asset, lets see where you'll be if you are in a 15% Marginal Federal Tax Bracket. Remember you won't pay taxes on the $100,000, just on the interest of $5,000. The taxes on the $5,000 of interest would amount to this;
$5,000 X 15% = $750 Oh,Oh!
Your bank account balance at the end of the year will be $$105,0000 less $750 or $104,250, still not too bad, after taxes you are earning 4¼% interest annually. But wait, what about inflation?
After Tax Income & Principal X Inflation Adjustment = After Tax, After Inflation Buying Power
$104,250 X 97% = $101,122.50
After Taxes, after adjusting for inflation you are earning 1.12% on your savings, still, you have to have savings, what can a person do? Nothing, we all have to have savings, this is just an example of what after tax inflation will do to you. No wonder the Fed is so sensitive about inflationary reports.
What if you had your $100,000 in something that moved up with inflation and showed a 5% return, suppose you put your $100,0000 into a piece of real property that would keep up with inflation, you pay cash for the property, and the property goes up in value 3%, right along with inflation.
Property Value X Annual Inflationary Rate = Year End Value
$100,000 X 1.03% = $103,000
Still, that $3,000 in earnings is taxable, by the time you sell the property and pay the taxes on the $3,000 gain, you haven't gone anywhere anyway, so stay with the bank, unless it's a long term investment. Or, an extremely fast turn-around.
Look what happens if you buy real property, but use leverage, a small down payment, and the rest financed with a loan. You buy a $400,000 piece of property with $100,000 down. It’s a four-plex, so you'll have some cash flow and your earnings will be sheltered, plus some of the shelter should cover any interest you have coming from other bank accounts. You must remember that real estate is a long term investment, it is not too liquid, that is to say you can't take the money out as fast as you can at the bank. The four-plex keeps up with inflation to the tune ♬ of 3% a year, this is what you will have;
Four-Plex Value X Inflationary Rate = End of Year Value
$400,000 X 1.03% = $412,000
What have you earned before Taxes & Expenses of Sale?
Value of Four-Plex – Loans of Record = Your Before Sale, Before Taxes Equity
$400,000 – $300,000 = $112,000
You can see that with leverage you are earning 12% on your money, the earnings are astounding over a period of years, but be careful, real estate doesn't go up in value every year.
This should give you a fairly solid understanding of the inflationary benefits of real estate. In another writing we will go into this fun little subject in greater detail.
Regardless, we can pretty well count on this building giving a total return of $37,640 the first year. This return is measured against one of three factors, our cash down payment, our after sale equity, or our before sale equity. This first year we will measure it against our cash down payment. Most investors, and broker/salespersons measure the returns against the original Cash Down Payment, we will learn later that the returns are more accurately measured against Before Sale Equity and the After Sale Equity.
Rule of 72
This first year finds us with a noticeable return of 47.05%, if we could keep this up indefinitely, and using
the "RULE OF 72"
we would double our money every 1.53 years, or in 1 year and 7 months. The fact is that
we probably couldn't sell the building and make much profit because of our expenses of sale. In this case, since
the building would now be worth $432,000 and our expenses of sale would be 7½% of $432,000 we would net
($400) after the sale. We would have a taxable gain of approximately $10,000 because of the depreciation we
have taken. Regardless, to get an understanding we need to look at what the building will do for the next five
years assuming 8% rent raises and 8% value increases.
YEAR II OF OWNERSHIP
CASH FLOW YEAR II
Gross Scheduled Income $46,000
Vacancy Factor 2% ($ 920)
Gross Operating Income $45,080
Expenses of Operation 20% ($ 9,200)
Net Operating Income $35,880
New 1st Trust Deed ($33,672) = $316,000
Cash Flow Year Two $ 2,208
You should note that even though our rents are up $3,400, our actual cash flow is down $811. This is
because of two things; 1. The loan payments are higher this 2nd year, and 2. the vacancy factor and expenses are
figured as a percentage of the Gross Scheduled Income
. Now we want to figure the tax savings for this 2nd year.
TAX PICTURE YEAR II
Gross Scheduled Income $46,000
Less Vacancy Factor ($ 920)
Less Expenses of Operation ($ 9,200)
Less Interest Expense of 1st Trust Deed ($31,884)
Less Depreciation ($10,182)
Total Deductions ($52,186) ($52,186)
Net Tax Loss or Gain - - - - - - - - - - - - ($ 6,186)
FEDERAL INCOME TAXES WOULD BE FIGURED ON $80,000 – $6,186 = $73,814
Income X Bracket = Taxes Due
$36,900 X 15% = $ 5,535
$36,914 X 28% = $10,336
Taxable Income $73,814 Total Federal Taxes Due $15,871
You will remember or look back and find that the old Federal Tax Bill without the building was $17,603 and the new bill is $15,871, so for Federal Taxes the couple has saved $1,732. Your Federal Marginal Bracket of 28% as we figured out before would be multiplied against the $6,186 of tax savings and you would come up with $1,732. Conversely, if we divided the $1,732 in tax savings by the $6,186 of tax write-off, we would come up with a 28% Federal Marginal Tax Bracket.
STATE INCOME TAXES
WOULD BE FIGURED ON $80,000 – $6,186 = $73,814
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$73,814 X 0.093 – $2,999.04 = $3,865.66
The old State Tax Bill was $4,441 and the new is $3,866, so we have a tax savings here of $575. If we apply our State Marginal Tax Bracket of 9.03% against the $3,866 in write-off, we will come up with a tax savings of $575.
TOTAL TAX SAVINGS AND CASH FLOW YEAR II
Federal Tax Savings $1,732
State Tax Savings $ 575 = Tax Savings Year II, $2,307
Cash Flow From Building $2,208
After Tax Cash Flow (ATCF) $4,515
AFTER TAX SPENDABLE INCOME WITHOUT THE BUILDING
TOTAL INCOME $111,450
LESS TAXES WITHOUT BUILDING ($ 22,044)
AFTER TAX OR SPENDABLE INCOME $ 89,406
AFTER TAX CASH FLOW WITH BUILDING YEAR II
TOTAL INCOME $111,450
CASH FLOW FROM BUILDING $ 2,208
NEW TAXES WITH BUILDING ($ 19,737)
AFTER TAX SPENDABLE INCOME $ 93,921
INCREASED SPENDABLE INCOME OWNING THE BUILDING, YEAR II
NEW AFTER TAX SPENDABLE INCOME $93,921
OLD AFTER TAX SPENDABLE INCOME ($89,406)
INCREASED SPENDABLE CASH $ 4,515
TOTAL RETURNS ON THE BUILDING, YEAR II
Assuming the building increases in value an average of 8% annually, this second year our real returns will be as follows;
Cash Flow Year II $ 2,208
Tax Savings $ 2,307
Equity Build Up $ 1,974
Appreciation $34,500
Total Returns Year II $40,989
Earlier we talked about figuring the returns on;
1. Cash Down Payment 2. Before Sale or Gross Equity 3. After Sale or Net Equity
All three are used to measure returns, depending on who is calculating the returns. We can calculate that the loan is currently paid down to $317,747 at the end of this 2nd year and if we multiply the original building value by 1.08 two times, or 1.17 one time we will come up with a current building value of $466,500. You must remember that real estate markets do not move in a constant direction, the waver from year to year, and what we said was that we could normally figure a 8% annual increase in value, in Southern California over a 5 year period. Still for this course what we want to do is estimate the tax ramifications of a building over a 5 year period. If you are in an area where building values go up 4% a year and rents go up 5% a year, then you will have to calculate the actual numbers for that area. What we attempt here is to gain an understanding of the effects of Income Property on an Investor, before and after taxes, in hopes that we will ultimately become proficient enough to explain these tax ramifications when necessary, hoping that information will end up in a sale profitable to everyone involved.
1. Cash Down Payment = Original Cash Down Payment + Acquisition Costs
2. Gross Equity = Current Building Value – Loans
3. Net Equity = Current Building Value – Loans – Expenses of Sale
OR, In the case of our example at The End of Year II we would have;
1. Cash Down Payment = = $ 80,000
2. Gross Equity = $466,500 – $317,747 = $148,753
3. Net Equity = $466,500 – $317,747 – $ 34,900 = $113,853
If we now divide our total year II returns by our down payment and two different equities, we will come up with three different returns. All our used, the choice is yours. Down Payment is the most common measuring stick.
TOTAL RETURN ON DOWN PAYMENT, YEAR II
RETURN $40,989
DOWN PAYMENT = $80,000 = 51.24%
TOTAL RETURN ON GROSS EQUITY, YEAR II
RETURN $40,989
GROSS EQUITY = $148,753 = 27.56%
TOTAL RETURN ON NET EQUITY, YEAR II
RETURN $ 40,989
NET EQUITY = $113,853 = 36.00%
The Cash Down Payment will remain the same each year. This will give you an ever greater return as the building will be performing more profitably, each year, providing you consistently raise your rents. You should further realize that you will have to compute the Gross Equity and the Net Equity Annually. Most computer programs will do this for you so the calculations aren't as difficult, or time consuming as they once were.
YEAR III OF OWNERSHIP
CASH FLOW YEAR III
Gross Scheduled Income $49,680
Vacancy Factor 2% ($ 994)
Gross Operating Income $48,686
Expenses of Operation 20% ($ 9,936)
Net Operating Income $38,750
New 1st Trust Deed ($33,859) = $315,576
Cash Flow Year Three $ 4,891
TAX PICTURE YEAR III
Gross Scheduled Income $49,680
Less Vacancy Factor ($ 994)
Less Expenses of Operation ($ 9,936)
Less Interest Expense of 1st Trust Deed ($31,668)
Less Depreciation ($10,182)
Total Deductions ($52,780) ($52,780)
Net Tax Loss or Gain - - - - - - - - - - - - ($ 3,100)
FEDERAL INCOME TAXES WOULD BE FIGURED ON $80,000 – $3,100 = $76,900
Income X Bracket = Taxes Due
$36,900 X 15% = $ 5,535
$40,000 X 28% = $11,200
Taxable Income $76,900 Total Federal Taxes Due = $16,735
You will remember that the old Federal Tax Bill without the building was $17,603 and the new bill is $16,735, so for Federal Taxes the couple has saved $868 in taxes this third year.
STATE INCOME TAXES WOULD BE FIGURED ON $80,000 — $3,100 = $76,900
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$76,900 X 0.093 – $2,999.04 = $4,152.66
The old State Tax Bill was $4,440.96 and the new is $4,152.66, so we have a savings of $288.30.
TOTAL TAX SAVINGS AND CASH FLOW YEAR III
Federal Tax Savings $ 868
State Tax Savings $ 288 = Tax Savings Year III, $1,156
Cash Flow From Building $4,891
After Tax Cash Flow (ATCF) $6,047
AFTER TAX SPENDABLE INCOME WITHOUT THE BUILDING
TOTAL INCOME $111,450
LESS TAXES WITHOUT BUILDING ($ 22,040)
AFTER TAX OR SPENDABLE INCOME $ 89,406
AFTER TAX CASH FLOW WITH BUILDING YEAR III
TOTAL INCOME $111,450
CASH FLOW FROM BUILDING $ 6,047
NEW TAXES WITH BUILDING ($ 20,888)
AFTER TAX SPENDABLE INCOME $ 96,609
INCREASED SPENDABLE INCOME OWNING THE BUILDING, YEAR III
NEW AFTER TAX SPENDABLE INCOME $ 96,609
OLD AFTER TAX SPENDABLE INCOME ($ 89,406)
INCREASED SPENDABLE CASH $ 7,203
TOTAL RETURNS ON THE BUILDING, YEAR III
Assuming the building increases in value an average of 8% annually, this third year our real returns will be as follows;
Cash Flow Year III $ 4,891
Tax Savings $ 1,156
Equity Build Up $ 2,181
Appreciation $34,500
Total Returns Year III $42,728
TOTAL RETURN ON DOWN PAYMENT, YEAR III
RETURN $42,728
DOWN PAYMENT = $80,000 = 53.41%
TOTAL RETURN ON GROSS EQUITY, YEAR III
RETURN $ 42,728
GROSS EQUITY = $218,568 = 19.55%
TOTAL RETURN ON NET EQUITY, YEAR III
RETURN $ 42,728
NET EQUITY = $178,638 = 23.92%
YEAR IV OF OWNERSHIP
CASH FLOW YEAR IV
Gross Scheduled Income $53,655
Vacancy Factor 2% ($ 1,073)
Gross Operating Income $52,582
Expenses of Operation 20% ($10,731)
Net Operating Income $41,851
New 1st Trust Deed ($33,859) = $313,167
Cash Flow Year Four $ 7,992
TAX PICTURE YEAR IV
Gross Scheduled Income $53,655
Less Vacancy Factor ($ 1,073)
Less Expenses of Operation ($10,731)
Less Interest Expense of 1st Trust Deed ($31,449)
Less Depreciation ($10,182)
Total Deductions ($53,435) ($53,435)
Net Tax Loss or Gain - - - - - - - - - - - - - - $ 230
You will want to notice that this is the first year that we have any income taxes on the building. Since the $230 is a positive number, it is not a deduction, but a gain. We have a cash flow of $7,992, but it is taxed as if it were $230. Nice!!!
FEDERAL INCOME TAXES WOULD BE FIGURED ON $80,000 + $230 = $80,230
Income X Bracket = Taxes Due
$36,900 X 15% = $ 5,535
$43,330 X 28% = $12,132
Taxable Income $80,230 Total Federal Taxes Due = $17,667
You will remember that the old Federal Tax Bill without the building was $17,603 and the new bill is $17,667, so for Federal Taxes the couple has to pay $64.
STATE INCOME TAXES WOULD BE FIGURED ON $80,000 + $230 = $80,230
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$80,230 X 0.093 – $2,999.04 = $4,463.35
The old State Tax Bill was $4,440.96 and the new is $4,463.35, so we have a tax loss of $21.39.
TOTAL TAX SAVINGS AND CASH FLOW YEAR FOUR
Federal Tax Savings ($ 64)
State Tax Savings ($ 21) = Taxes Paid Year IV $ 85
Cash Flow From Building $ 7,992
After Tax Cash Flow (ATCF) $ 7,907
AFTER TAX SPENDABLE INCOME WITHOUT THE BUILDING
TOTAL INCOME $111,450
LESS TAXES WITHOUT BUILDING ($ 22,044)
AFTER TAX OR SPENDABLE INCOME $ 89,406
AFTER TAX CASH FLOW WITH BUILDING YEAR IV
TOTAL INCOME $111,450
CASH FLOW FROM BUILDING $ 7,907
NEW TAXES WITH BUILDING ($ 22,130)
AFTER TAX SPENDABLE INCOME $ 97,227
INCREASED SPENDABLE INCOME OWNING THE BUILDING, YEAR IV
NEW AFTER TAX SPENDABLE INCOME $97,227
OLD AFTER TAX SPENDABLE INCOME ($89,406)
INCREASED SPENDABLE CASH $ 7,821
TOTAL RETURNS ON THE BUILDING, YEAR IV
Assuming the building increases in value an average of 8% annually, this year our real returns will be as follows;
Cash Flow Year IV $ 7,992
Tax Savings ($ 85)
Equity Build Up $ 2,410
Appreciation $40,000
Total Returns Year IV $50,317
TOTAL RETURN ON DOWN PAYMENT, YEAR IV
RETURN $50,317
DOWN PAYMENT = $80,000 = 62.90%
TOTAL RETURN ON GROSS EQUITY, YEAR IV
RETURN $ 50,317
GROSS EQUITY = $274,205 = 18.35%
TOTAL RETURN ON NET EQUITY, YEAR IV
RETURN $ 50,317
NET EQUITY = $230,282 = 21.85%
YEAR V OF OWNERSHIP
CASH FLOW YEAR V
Gross Scheduled Income $57,947
Vacancy Factor 2% ($ 1,159)
Gross Operating Income $56,788
Expenses of Operation ($11,589)
Net Operating Income $45,199
New 1st Trust Deed ($33,859) = $310,7509
Cash Flow Year Five $11,340
TAX PICTURE YEAR V
Gross Scheduled Income $57,947
Less Vacancy Factor ($ 1,159)
Less Expenses of Operation ($11,589)
Less Interest Expense of 1st Trust Deed ($31,199)
Less Depreciation ($10,182)
Total Deductions ($54,129) ($54,129)
Net Tax Loss or Gain - - - - - - - - - - - - - $ 3,818
FEDERAL INCOME TAXES WOULD BE FIGURED ON $80,000 + $3,818 = $83,818
Income X Bracket = Taxes Due
$36,900 X 15% = $ 5,535
$46,918 X 28% = $13,137
Taxable Income $83,818 Total Federal Taxes Due $18,672
The old Federal Tax Bill without the building was $17,603 and the new bill is $18,672, so for Federal Taxes the couple has to pay $1,069.
STATE INCOME TAXES WOULD BE FIGURED ON $80,000 + $3,818 = $83,818
Taxable Income X Taxable Rate less Taxes Already Computed = Taxes Due
$83,818 X 0.093 – $2,999.04 = $5,047.49
The old State Tax Bill was $4,440.96 and the new is $5,047.49, so we have $606.53 more to pay in State Taxes.
TOTAL TAX SAVINGS AND CASH FLOW YEAR FIVE
Federal Tax Savings ($ 1,069)
State Tax Savings ($ 607) = Tax Savings Year V ($1,676)
Cash Flow From Building $ 9,664
After Tax Cash Flow (ATCF) $ 7,988
AFTER TAX SPENDABLE INCOME WITHOUT THE BUILDING
TOTAL INCOME $111,450
LESS TAXES WITHOUT BUILDING ($ 22,044)
AFTER TAX OR SPENDABLE INCOME $ 89,406
AFTER TAX CASH FLOW WITH BUILDING YEAR V
TOTAL INCOME $111,450
CASH FLOW FROM BUILDING $ 9,664
NEW TAXES WITH BUILDING ($ 23,720)
AFTER TAX SPENDABLE INCOME $ 97,394
INCREASED SPENDABLE INCOME OWNING THE BUILDING, YEAR V
NEW AFTER TAX SPENDABLE INCOME $ 97,394
OLD AFTER TAX SPENDABLE INCOME ($ 89,406)
INCREASED SPENDABLE CASH $ 7,988
TOTAL RETURNS ON THE BUILDING, YEAR V
Assuming the building increases in value an average of 8% annually, our year V returns will be as follows;
Cash Flow Year V $ 9,664
Tax Savings ($ 1,676)
Equity Build Up $ 2,662
Appreciation $45,000
Total Returns Year V $55,650
TOTAL RETURN ON DOWN PAYMENT, YEAR V
RETURN $55,650
DOWN PAYMENT = $80,000 = 69.56%
TOTAL RETURN ON GROSS EQUITY, YEAR V
RETURN $ 55,650
GROSS EQUITY = $335,416 = 16.59%
TOTAL RETURN ON NET EQUITY, YEAR V
RETURN $ 55,650
NET EQUITY = $287,100 = 19.38%
You notice that the return on the cash down payment increases each year. The most accurate return, I feel, is on the Net Equity, as this is the real investment that the investor has in the building.
★ SELL THE BUILDING AND PAY TAXES ON THE GAIN ★
When you want to estimate the taxes upon the sale of any building you have to know the tax basis of the property. The tax basis simply stated is;
Purchase Price + Acquisition Costs + Capital Improvements – Depreciation = Adjusted Tax Basis
The real cost of the building would be the purchase price, plus loan points and escrow fees. The fees for a buyer on an apartment building are normally 1½% plus the loan points. If, when our couple bought this building they had loan points of 1½% we would simply add 1½% + 1½% = 3%, we would then take 3% of the base purchase price, in this case $400,000 and come up with closing costs of $12,000. This is just a simple rule of thumb for estimating acquisition costs on apartment buildings and most real estate for that matter. In another class you will learn to figure acquisition costs in more detail. For now we will use our rule of thumb.
BASIS OF BUILDING AT PURCHASE
BUILDING COST X 3% = ESTIMATED ACQUISITION COSTS
$400,000 X 3% = $12,000
(Another easy and fairly accurate way to calculate Acquisition Costs is to multiply 1½% of the buildings purchase price, then add the loan points)
Each Year for 5 years the owners depreciated $10,182, so they have depreciated the building $50,910.
Annual Depreciation X Years = Depreciation Taken
$10,182 X 5 Years = $50,910
FIND CURRENT ADJUSTED TAX BASIS
Purchase Price $400,000
Plus Acquisition Costs $ 12,000
Less Depreciation ($ 50,910)
Plus Capital Improvements $ 0
Adjusted Tax Basis of Building $361,090
ESTIMATED VALUE OF BUILDING
At 8% a Year for 5 Years the building would be worth approximately $590,000
ESTIMATED GAIN ON SALE
Sales Price $590,000
Less Expenses of Sale at 7½% ($ 44,250)
Less Adjusted Tax Basis ($361,090)
Estimated Gain Upon Sale $184,660
This $184,660 would be added to the taxable income as Long Term Capital Gain (asset heldover 1 year). So we would have $80,000 + $184,660 = $264,660.
Now we want to figure the total taxes due, and the taxes due on the gain from the sale of the building.
FEDERAL
INCOME TAX BRACKETS 1993
MARRIED FILING JOINTLY
Taxable Income Bracket Taxes
Income X Bracket = Taxes Due
$ -0- to $ 36,900 X 15% = $ 5,535
$ 36,901 to $ 89,150 X 28% = $14,630
$ 89,151* to $140,000 X 31% = $15,763
$140,001 to $250,000 X 36% = $39,560
More than $250,000 X 39.6% = $ ???
FEDERAL TAXES DUE TO SALE OF BUILDING
Income X Bracket = Taxes Due
$ 36,900 X 15% = $ 5,535
$ 52,250 X 28% = $ 14,630
$ 50,850 X 31% = $ 15,763
$110,000 X 36% = $ 39,400
$ 14,660 X 39.6 = $ 5,805
Taxable Income $264,660 Total Federal Taxes Due $ 81,133
FEDERAL TAXES DUE TO THE SALE OF THE BUILDING
NEW TAXES $81,133
OLD TAXES ON $80,000 ($22,044)
FEDERAL TAXES DUE
TO THE SALE OF THE BUILDING $59,089
Notice that the Federal Marginal Tax Bracket just on the gain of the building is 32%
Taxes $ 59,089
Gain = Marginal Tax Bracket, or; $184,660 = 32.00%
WHAT ABOUT STATE TAXES
Dollar Gain From Sale of Building + Regular Income = Total Taxable Income
$184,660 + $80,000 = $264,660
STATE TAXES WOULD BE
$264,660 X 0.100 – $4,485.70 = $ 21,980.30
STATE TAXES ATTRIBUTABLE TO THE SALE OF THE BUILDING
New State Taxes $21,980.30
Less Old State Taxes ($ 4,440.96)
Taxes On Building Gain $17,539.34
STATE MARGINAL TAX BRACKET FOR SALE OF BUILDING
Taxes $ 17,539.34
Gain = Marginal Tax Bracket, or; $184,660.00 = 9.50%
TOTAL TAXES, STATE AND FEDERAL
ATTRIBUTABLE TO THE SALE OF THE BUILDING
Federal Taxes $ 59,089
State Taxes $ 17,539
Total Taxes, State & Federal $ 76,628
FIND COMBINED, STATE & FEDERAL,
MARGINAL INCOME BRACKET FOR GAIN ON BUILDING
Total Taxes $ 76,628
Gain = Marginal Tax Bracket, or; $184,660 = 41.50%
ESTIMATED AFTER SALE NET CASH
The after sale net cash is a completely different number, or calculation, from the calculation used for taxes. It is incredibly important that you remember when you are figuring taxes, never use the loan in the calculation;
Selling Price of Building