02 08 real estate a tax and investment critique

7/27/2019 02 08 Real Estate a Tax and Investment Critique

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Real Estate:A Tax andInvestment Critique

Cal Brown, MST, CFP


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I RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E

2007 The Monitor Group, Inc. All rights reserved.

1430 Spring Hill Road, Suite 400, McLean, VA 22102

(703) 288-0500 FAX: (703) 288-0900

[email protected]

Is real estate

the best way

to make a lotof money?


3/16

RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E I 1

People continue to fall in love with rental real

estate, oftentimes for good reason. Anecdotal

quotes abound. Mark Twain said, Buy land,

theyre not making it any more. Donald Trump

exclaimed: Well, real estate is always good, as far as

Im concerned.1 His ex-wife Ivana added: I made a

tremendous amount of money on real estate. Ill take

real estate rather than go to Wall Street and get 2.8

percent. Forget about it. She also noted, I always felt

very secure and very safe with real estate. Real estatealways appreciates.2

Even Hollywood has contributed to real estates

allure with stock market mogul Gordon Geckos

character from the movie Wall Street, You see that

building? I bought that building ten years ago. My first

real estate deal. Sold it two years later, made an

$800,000 profit . . . At the time I thought that was all

the money in the world. Now its a days pay.

Robert Kiyosaki, author of the best-seller Rich

Dad, Poor Dadteaches readers theyll never get rich bychasing a higher salary. . . . concentrate your efforts

on only buying income-generating assets.3 Such as?

Whenever Kiyosaki offers an example from his life, it

almost invariably involves investing in rental real-

estate. Author Robert Allen has written excellent

books,Nothing Down and Creating Wealth, and

continues to train people through seminars and other

methods in how to reap profits in real estate.

Many other books have been written on the

advantages of buying houses and renting them out.

Infomercials and seminars throughout the country

have created a legitimate business teaching investors

how to succeed in this investment realm. This is not a

hoax by any means; however, some of the investingrealities are glossed over or omitted. As Mark Twain

said: It aint what you dont know that gets you into

trouble. Its what you know for sure that just aint so!

Buried deep in Kiyosakis advice on behavior

modification and attitude adjustment is the

requirement to do the hard work necessary for

financial success; he revealed he examined

approximately 1,000 possible real estate deals in order

to invest in ten, and three of the ten lost money. It is

quite clear the amount of analysis necessary to select asuccessful real estate investment is, at least, a

tremendous amount of work.

This paper takes a critical look at the investment

and tax implications of residential real estate. It does

1 Donald Trump interview. Wall $treet Week with FORTUNE, July 26, 20022 http://en.thinkexist.com/quotes/ivana_trump/3 Robert Kiyosaki, Rich Dad, Poor Dad, Time Warner Paperbacks, 2002

Real Estates Upside

According to many wealthy people, real estate is the greatest

investment of all time. But is that really the case? This article will

critically examine the investment and tax implications of rental real

estate. In analyzing a real estate investors long term prospects, the right

question to ask is not, Can real estate make me a lot of money? Certainly, it

has made millions for many. Heres the real question: Is real estate the best

wayto make a lot of money? The answer requires more evaluation than most

real estate investors are willing to perform.


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There are established standards by which to

measure investment returns for financial assets

such as stocks, bonds, and mutual funds. No

such standard exists in the rental real estate universe.

Let me see your report cardGlobal Investment Performance Standards

(GIPS) are a set of ethical principles which establish

a standardized, industry-wide approach to how

investment firms should calculate and report their

investment results both to clients and to prospective

clients in a way that ensures fair representation and

full disclosure4.

These standards, while complex, accurately

portray the widely accepted method which

professionals agree represents the actual return on an

investment, considering not only capital appreciation,

but also income (dividends, interest, etc.), the timing

of deposits and withdrawals, the time period

measured, and expenses. A time-weighted net rate of

return is a clear, understandable, and precise reporting

of an investment performance for a given time period.

The Monitor Group, Inc. uses these criteria when

reporting investment performance to clients.

For example, when a mutual fund company

reports the investment returns for a particular fund, it

specifies the time frame (one year, five years, ten years,

etc.) and the returns reported have been carefully

calculated according to these industry standards.

Since they are subject to audit by the Securities andExchange Commission, the fund company is subject

to significant fines and other penalties, if found to be

not in compliance with the standards. This is serious

business.

Because rental real estate has no such reporting

standards, investors simply tell their story in an

informal way. Unfortunately, it is not possible to

verify the actual time-weighted net rate of return

without all of the facts. A financial audit of all the

data would be necessary to determine the trueinvestment performance of a given property.

Rental real estate investors typically leave out key

data points when discussing their results. Primarily,

they neglect the time value of money. A house

bought one year ago for $100,000 and sold at the end

of that year for $200,000 has a different annualized

rate of return than another house bought 20 years ago

for $100,000 and sold at the end of the current year

for $200,000. The former has an annual return of

100%; the latter, a 3.53% average annual return (seeCHART ONE). This is a time-weighted, annualized rate

of return in its simplest form. It assumes a single

investment at the beginning and no further cash flows,

in or out.

2 I RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E

not consider other viable forms of real estate

investment, such as raw land, development,

commercial rentals, Real Estate Investment Trusts

(REITs), etc. The author is not predisposed for or

against investing in rental real estate. Rather, he is

attempting to evaluate the typical investment in rental

properties from a dispassionate, analytical perspective.

Before anyone becomes a real estate investor, they

should understand how to measure both the

performance and the tax implications of their

investment.

4 The GIPS standards were based on and preceded in North America by the AIMR Performance Presentation Standards. The AIMR-PPS standardsbecame the U.S. and Canadian version of GIPS in 2001. AIMR-PPS standards converged with the GIPS standards on 1 January 2006. For moreinformation, see the CFA Institute website, http://www.cfainstitute.org/centre/ips. AIMR is an acronym for Association for Investment Management andResearch, now known as the CFA Institute. CFA is an acronym for Chartered Financial Analyst.

The Measures of Investment Performance


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5 Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2nd Edition, 2005, spreadsheet data for Figure 2.1

6 ibid; Professor Shiller also compiles inflation data in his spreadsheet from several sources: George F. Warren & Frank A. Pearson from 1890-1912, and theU.S. Bureau of Labor Statistics from 1913-2005. The author located an inflation calculator on the web which gave similar results; i.e., an average 2.68%annually from 1890-2005. http://westegg.com/inflation.infl.cgi. Warren & Pearson maintain a website at http://www.globalfinancialdata.com.

C H A R T O N E

Time Value of Money

Bought in

2005

Sold in

2006

Average AnnualReturn = 100%

Bought in

1986

Sold in

2006

Average AnnualReturn = 3.53%

2o Years

1 year

However, with real estate, there are other data

points to factor in. Was there rental income during

the period? Was the house bought for cash, or was a

loan involved? How does the investor factor the loan

payments into the return calculation? Most probably,

there were many other expenses associated with the

property; some were expensed, others were

capitalized. And how is depreciation handled for

purposes of calculating the net return?

Up, up, and away?

How has real estate performed as an investment?

Robert J. Shiller of Yale University, author ofIrrational

Exuberance could not find a long-running index of

house prices for the United States, so he built one (see

CHART TWO). He combined government surveys with

for-sale listings his students found in old newspapers.

Shillers data begins with 1890. His index shows an

average annual real (adjusted for inflation) return of

0.55% per year through 2005.5 If inflation is assumed

to be 2.66% over that time6, the nominal average

annual return is 3.21%. As far as we know, this is the

best data available to analyze performance.


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There is good historical data on REITs (Real

Estate Investment Trusts, but REITs are primarily

commercial real estate ventures. Because this paper

examines residential real estate investments, this data

will not be discussed herein.

The average annual percentage increase in the

value of new and existing homes over the last 20-40

years ranges from 4.4% to 6.3% (data compiled from

various sources, including the U.S. government) see

CHART THREE.

All of these time periods end before the current

slump in housing prices, which began in 2006. This is

not exactly double-digit price appreciation. Frankly,

this does not come close to comparable 20+ years of

equity returns in the stock market, despite what IvanaTrump thinks. Over similar time frames, both large

and small capitalization stocks significantly out-

performed the price appreciation of single-family

homes shown above, ranging from 10.3% to 16.2%

annually see CHART FOUR.

7 U.S. Dept. of Housing and Urban Development, Office of Policy Development and Research,US Housing Market Conditions: Historical Data

8 ibid

9 U.S. Dept. of Commerce, Bureau of the Census, New One-Family Houses Sold and For Sale, Series C-25

10 U.S. Dept. of Housing and Urban Development, Office of Policy Development and Research,US Housing Market Conditions: Historical Data

C H A R T T W O

Home Price Index

1890 20051920 1940 1960 1980

Source: Irrational Exuberance: Second Edition

100

185

C H A R T T H R E E

Housing Value Performance:Four Comparitive Studies

DATA A: 21 years (1980-2000)7

DATA B: 33 years (1968-2000)8

DATA C: 34 years (1969-2002)9

DATA D: 38 years (1963-2000)10

4.41%

6.30% 6.20% 6.19%

AverageAnnualPercentageIncreaseinV

alue

0

5%

10%

A B C D


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11 Fama/French U.S. Large Cap Index

12 Fama/French U.S. Small Cap Index


Brother, can you loan me a . . .

One way real estate investors significantly boostreturns is through the concept of leverage, also known

as OPM (Other Peoples Money). In fact, most realestate is bought with a mortgage loan. A simple

example illustrates how a cash investment of $20,000can purchase a house worth $100,000, and produce a

100% return to the investor on only a 40% increase inthe price of the house (see CHART FIVE).

In this over-simplified example, the investor did

not get a 40% return (from $100K to $140K). Rather,

she doubled her money. How? She only put up $20K

of her own money, and the property increased in

value by $40K. This of course ignores the cost of the

interest on the loan and the fact several monthly

payments were made, effectively increasing the

amount of her investment in the property (and

reducing her actual return). Nevertheless, a loan does

increase the net return realized by the investor.

However, leverage can be used in other types of

investing as well, including the stock market. It is

possible to buy stocks using a margin loan. However,

due to the potential abuse and problems associated

with margin calls, a margin loan is limited to 50% of

the account value. On the other hand, a mortgage on

an investment property can be up to 80% 100% of

the property value, in certain cases.

C H A R T F I V E

Investing with Other Peoples Money

Down-payment$20,000

Net Proceeds$40,000Profit of

$20,000 = 100%

House Value

Increased 40%

C H A R T F O U R

Housing Value Compared to Investment Performance:Four Comparitive Studies

DATA D: 38 years(1963-2000)10

AverageAnnualPercentageIncreasein

Value

0

5%

10%

15%

20%

Average Annual Percentage Increase in Value of Homes

Average Annual Percentage Increase in Large Cap Stocks11

Average Annual Percentage Increase in Small Cap Stocks12

4.41

6.30 6.20 6.19

16.17

13.90

11.95 11.7611.23

10.32

12.02

13.54

A

BC

D

DATA A: 21 years(1980-2000)7

DATA B: 33 years(1968-2000)8

DATA C: 34 years(1969-2002)9


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Most people do not use margin loans to invest in

stocks because the stock market is perceived to be too

volatile. However, for real estate the perception of low

risk is due to an absence of data on the short-term

volatility of prices on single family homes because

these prices are not published daily in the newspaperor online. The daily reporting of stock prices

emphasizes volatility in those markets.

With a home loan, there is no margin call, as there

can be when buying stocks on margin. A margin call

forces the investor to either deposit more cash to the

account, or to sell some positions to keep the margin

loan at less than 50% of the portfolio value. A similar

scenario could occur in rental real estate if the investor

is unable to make payments on the loan due to

insufficient cash flow; in that case, a forced sale maybe required.

As the current housing slump has proven, home

prices actually can go down. Most of the time, people

forget that fact. The commonly accepted belief is that

one cannot lose money on an investment in a house.

When confronted with a real estate bear market as we

are presently experiencing, most people believe, givena relatively short period of time, prices will bounce

back. While it is true that prices will eventually

recover, it may or may not be in a short period of

time.

The fact of the matter is, both real estate and

financial assets have historically increased in value

over time, and the longer the time period, the higher

the probability there will be a profit. Both categories

will eventually recover from any price decline; markets

are cyclical. Frankly, stock market investors couldlearn a valuable lesson from real estate investors:

patience.

Real Estate Tax Benefits:Real or Imagined?

Just as real estate investors adhere to centuries-old

wisdom regarding the investment potential of

houses and land, they also tend to remember

decades-old tax laws. Unfortunately, just as

investment trends are neither permanent nor

predictable, tax laws are constantly changing.

Where were you?

A little over 20 years ago Congress enacted

legislation which completely overhauled the tax code.

It was known as the Tax Reform Act of 1986 (TRA

86), and it had devastating consequences for realestate investing and other so-called tax shelters.

Prior to 1986, the tax code was the real estate

industrys best friend.

Depreciation was one victim of the Act. Before

TRA 86, accelerated depreciation was available for real

estate. A property could be depreciated over only 19

years, using the 175% declining balance method of

depreciation. This method allowed a larger proportion

of the investment cost to be written off in the earlier

years of the depreciation period. However, TRA 86 not

only lengthened the cost recovery period of most real

propertynon-residential property to 39 years and

residential rental property to 27.5 yearsit also

eliminated the 175% declining balance write-off

method. Instead, it required the use of the straight-

line method. To be technically accurate, it is still

permissible to depreciate certain building components

(rental appliances, carpet, furniture, etc.), over 3, 5, or

7 year recovery periods using accelerated depreciation,

but this has only a modest impact on the overall

depreciation.

The net result was investors could not deduct as

much depreciation after TRA 86 and this increased the

taxes they had to pay. Because depreciation is a non-

cash deductible expense, pre-TRA 86 taxable

incomeand consequently, taxeswere substantially

lower on a rental property. After 1986, the

depreciation deductions are much smaller, thus

taxable income and taxes are higher.


9/16


Loser, loser, loser

Another significant change in the legislation was

the introduction of Passive Activity Loss (PAL)

limitations; but this PAL is not a friend of real estate

investors. Before 1986, if rental expenses includingdepreciation exceeded incomethat is, there was a

lossthe investor could deduct the entire loss. There

was no limit on the loss allowable as a deduction

against other ordinary income. In fact, with

accelerated depreciation and the unlimited use of

rental losses, an investor could have vacancy factors of

50% or more and still make an after-tax profit.

However, TRA 86 limited both the amount of

PALs allowed and the AGI (Adjusted Gross Income)

eligibility for a taxpayer to deduct losses on rental realestate. In a nutshell, now the maximum PAL (in other

words, the maximum loss on rental real estate) a

taxpayer can deduct in any calendar year is $25,000.

This is known as a Special Loss Allowance for Real

Estate. Special, indeed. But not every taxpayer is

eligible to claim a loss. The $25,000 loss allowance is

reduced incrementally; the reduction is 50% of the

amount by which the taxpayers modified AGI exceeds

$100,000, and is completely phased out at modified

AGI of $150,000 (see CHART SIX).

Modified AGI for this purpose is AGI minus

Social Security benefits; but plus deductions for IRA

or other retirement plan contributions, as well as

deductions for one-half of self-employment tax,

qualified tuition and related expenses, and student

loan interest.13

Different rules apply for real estate professionals,

defined as those who spend more than 750 hours per

year in real property trades or businesses in which the

taxpayer materially participates, and perform more

than 50% of their personal services in these activities.

In this case, the $25,000 rental loss limitation does not

apply. This is advantageous if the property produces a

loss; however, if the property generates income and

the real estate agent has passive losses from other

sources, the rental activitys income cannot be offsetby those passive losses.14 Rental income from real

estate for such a professional is not subject to self-

employment tax, unless the rentals are received in the

course of a business as a real estate dealer.

Depreciation and the Special Loss Allowance work

hand in hand. The only benefit of depreciation is to

reduce income or increase a loss. However, if the loss

cannot be deducted, the depreciation is of little use.

But read on: theres danger in not deducting

depreciation on a tax return.

Excuse me . . .I have some questions!

This leads to two questions: 1) what happens to

the losses realized but not deductible? And 2) is

depreciation apermanentor a temporarydeduction?

The answer to the former is the losses are

suspended. A disallowed passive activity loss is

accumulated in a separate tax form. Year after year,

these suspended PALs accumulate until either the

taxpayer becomes eligible (that is, AGI is reduced

below the threshold) and some of the losses can be

deducted, or the property is disposed of. When the

property is sold, the suspended PALs can finally be

C H A R T S I X

Special Loss AllowanceFor Rental Real Estate The Maximum

Your Income You May Deduct(Modified Adjusted (Regardless of the amount

Gross Income) of your annual loss)

$100,000 $25,000

$110,000 $20,000

$120,000 $15,000

$130,000 $10,000

$140,000 $5,000

$150,000 $0

13 1040 Quickfinder Handbook, 2006 Tax Year, p. 8-5

14 1040 Quickfinder Handbook, 2006 Tax Year, p. 8-5 through 8-6


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15 1040 Quickfinder Handbook, 2006 Tax Year, p. 7-4

deducted. The good news is these losses reduce the

capital gain. The bad news is, the amount of the

accumulated depreciation is not taxed at the favorable

15% capital gains rate, but at a higher 25% rate (see

below).

Thus, the losses do eventually produce a benefit.However, the time value of money greatly reduces the

present value of the benefit from those losses.

Furthermore, if the property is sold when other

income is significantly lower, the deductible losses

cannot exceed the ordinary income for that year. For

example, a taxpayer retires and ordinary income drops

from well over $150,000 per year to less than $50,000.

If the property has suspended PALs totaling $80,000,

only $50,000 of the suspended losses would be

deductible in that year. The remaining

$30,000 would continue to be suspended and used

against ordinary income in a future year.

The answer to the second question is no less

complex, and it is not as taxpayer-friendly.

Depreciation is not a true expenseit is not a

permanent deduction; it is merely tax deferral.

Eventually, any depreciation on a property is

recaptured and then taxed at a higher rate.

Technically, it is unrecaptured Section 1250 gain.

When the property is sold, the part of the long-term

gain attributable to depreciation is taxed at a

maximum rate of 25%.

For example, if a rental property was purchased

several years ago for $280,000 and sold for $500,000,

the tax is not simply15% of the difference.Here is how the calculation of the tax liability

would be computed (see CHART SEVEN):

Thus, of the $260,000 gain, $220,000 is

attributable to appreciation and taxed at long-term

capital gains rates (maximum of 15%), but $40,000 of

the gain is attributable to depreciation and is taxed as

unrecaptured Section 1250 gain at a maximum rate of

25%.15

Thus, if a taxpayer was able to deduct

depreciationeither because the property produced a

profit or because she was eligible for the special

$25,000 loss allowanceshe would eventually have to

pay it back. It is unlikely there would be a benefit

from a delta in the tax brackets, either, because the

AGI limitation ensures folks in the 28% brackets and

above cannot deduct losses from rental real estate. In

other words, it is highly probable depreciation would

be deducted at a 15% or 25% bracket, and then taxed

C H A R T S E V E N

Depreciation and Taxation Rates

}0

$100,000

$200,000

$300,000

$400,000

$500,000

Sale Price of House = $500,000

DepreciationTaken$40,000

Adjusted Basis $240,000{

Total Gain

$260,000

$40,000 isTaxed at 25%(sec. 1250)Gain Rate

$220,000 is

Taxed at 15%(sec. 1231)Capital GainsRate

Original Cost$280,000

less


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later at a 25% rate. This is not a beneficial type of tax

deferral. It is better to take a deduction at a higher

rate and pay taxes later at a lower rate (for example,

the standard assumption of contributing to a

deductible IRA during peak earning years and

withdrawing later at a lower tax bracket).There is something even more disturbing about

depreciation and unrecaptured Section 1250 gain. If a

taxpayer did not deduct depreciation on his tax

returns because 1) he forgot about it or simply

neglected to take it, 2) he didnt realize he could

deduct it, or 3) he was being nice to the IRS and

chose not to take it, it doesnt matter. Even if a

taxpayer doesnt take the deduction, his basis will be

reduced by the amount of depreciation which should

have taken and that amount will later be taxed at the25% unrecaptured Section 1250 gain rate upon sale of

the property.

In fact, if a taxpayer is in Alternative Minimum

Tax (AMT), it is advisable to claim depreciation under

the alternative depreciation method. This method uses

a 40 year life, rather than 27.5 years. If a taxpayer is in

AMT, it is highly probable her AGI exceeds $150K,

and thus she cannot currently deduct depreciation

against taxable income; it is suspended. It would be

better to claim less depreciation now in order to have

less taxed at the 25% rate later.

Is it a rental or a residence?

What would happen if someone owned a rental

house for many years, and then moved into it as a

personal residence? Under Section 121 of the Internal

Revenue Code, if a taxpayer lived in a house as apersonal residence for two out of five years prior to

the sale, the person can exclude $250,000 ($500,000 if

married filing jointly) of the gain from the sale. In

other words, if the capital gain is less than that, its tax

free. So, one could rent the house out for any number

of years (including three of the last five), then live in it

for two years, sell it and take advantage of the 121

exclusion amount. However, the portion of the gain

attributable to depreciation will be taxed at the

unrecaptured Section 1250 gain rate of 25%, even ifthe total gain is less than $250,000 (or, $500,000).

The same applies to properties exchanged under

1031; more on this later.

In 2004, H.R. 4520 was signed into law by

President Bush. It added a requirement for a situation

described in the preceding paragraph; the property

must be owned for at least five years. That five year

requirement does not apply to a house used only as a

primary residence; it only applies if it was both a

rental property and the primary residence (see CHART

EIGHT). Revenue Procedure 2005-14, effective January

27, 2005 provides more information and examples

regarding this.

C H A R T E I G H T

Rental Exclusion for Capital Gains

Bought in2000

Year 1 Year 2 Year 3 Year 4 Sold in2005

2 Years asPrimary Residence

3 Years asR e n t a l P ro p e rt y

Bought in

2000

Year 1 Year 2 Year 3 Year 4 Sold in

2005




Qualifies

Bought in2000

Year 1 Year 2 Year 3 Year 4 Sold in2005

1 Year asPrimary Residence


Bought in

2001Year 2 Year 3 Year 4 Sold in

2005


Does Not Qualify


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1 0 I RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E

To summarize the potential tax impact of real

estate investing, it is quite probable an investor with a

high income from other sources cannot deduct any

depreciation or losses currently on their rental real

estate. However, whether or not it was possible to

deduct the depreciation, when the property isultimately sold the amount of the cumulative

depreciation taken will be taxed at the higher 25%

rate, rather than the 15% capital gains rate.

Do you want to make a trade?

A misnomer in the tax code is labeled a tax-free

exchange under Section 1031. Technically, it is not

tax-free; rather, it is a tax deferral mechanism. The one

exception to the previous statement is when a persondies owning a property acquired via a 1031 exchange,

he can transfer the property tax-free to his heirs

because of stepped-up basis.

There are three requirements for a 1031

exchange:

1) It must be business or investment property,

2) It must be like kind property, and

3) It must be an exchange.

A 1031 exchange is not available for a residenceor second home. It is a literal swapping of investment

properties. The courts have ruled the term like kind

has a very broad interpretation; in essence, any kind of

real estate is like kind with any other kind of real

estate.

Please note, a residence can be converted to a

rental property, and then transferred via a 1031

exchange. Conversely, a rental property obtained via a

1031 exchange can be converted to a residence which

can later be sold to take advantage of the 121 gain

exclusion of $250,000 ($500,000 for joint filers)

mentioned above.

An exchange can be made directly with another

real estate investor, or a qualified intermediary may be

used. Without a qualified intermediary, an investor

cannot sell one property, re-invest in another within

any period of time, and still qualify for a 1031

exchange.

In a 1031 exchange, no gain or loss is recognized,

but is deferred until a later disposition. The adjusted

basis of the former property is transferred to the new

property acquired. It is an effective means of delaying

capital gains taxes.

For example, suppose investor A owns a rentalhouse valued at $500,000; As adjusted basis is

$100,000. Investor B owns a property also valued at

$500,000; Bs adjusted basis is $250,000. If they

exchange their properties, there is no gain recognized.

Investor A transfers his $100,000 basis to the new

property, and B transfers his $250,000 basis to the

house formerly owned by A.

Depending on the basis of the old property, the

basis of the new property, and any mortgages

involved, it is possible for some gain to be recognized

at the time of the exchange. Briefly, if any cash is

received or if there is relief from any mortgage, that

part is taxable.

Investor B

$500,000Value

C H A R T N I N E

Section 1031 Property Exchange

Investor A

$500,000Value

$100,000 Adjusted Basis$250,000

Investor A

$500,000Value

Investor B

$500,000Value

$250,000Adjusted Basis $100,000

A and B TRADE PROPERTIES


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RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E I 1 1

As a further example, suppose Bs property is

worth $600,000. In order to make the deal work, A

agrees to trade his property worth $500,000 and give B

$100,000 cash. In this case, A pays no tax, and As basis

is now $200,000 ($100,000 transferred basis plus

$100,000 cash paid). B pays tax on the $100,000 cashreceived. Bs basis remains at $250,000 ($250,000

transferred basis plus $100,000 cash received, less

$100,000 subject to tax) see CHART TEN.

It is too involved to delve into the complexities of

mortgages with exchanges for the purposes of this

paper, but the tax consequences should be fully

calculated prior to effecting any 1031 exchange.

It is also important to note a 1031 exchange

delays the release of suspended losses (PALs)discussed above; an investor only receives the benefit

of suspended losses when there is a taxable event.

Finally, there are specific rules and time-frames

for identifying replacement property, closing, and

using a qualified intermediary. The exchange property

must be identified within 90 days, and closing must

occur within 180 days (or, the filing of the tax return,

if later). The taxpayer must dot the is and cross the ts.

Whats the bottom line?An investor should invest in rental real estate for

positive cash flow as a return on investment, and not

for the purpose of generating tax losses. The tax losses

will probably not be deductible, but will be

suspended. Although those suspended losses may

reduce the ultimate capital gain, the accumulated

depreciation will be taxed at a higher 25% rate. An

investor should invest in real estate if it will generate

exceptional annual profits (cash flow) now, and a

potential capital gain later; she should not invest inreal estate because of supposed tax benefits. An

investor should invest in real estate for real economic

benefits, not illusory tax breaks.

Conclusion

Many real estate investors have been very

successful in buying houses, renting them, fixing

them up, and selling them. This article does not

dispute that fact.

However, being a success as a landlord is not

guaranteed, and it is not easy to find, purchase and

manage a profitable property. Spectacular reports of

profits and investment results should be questioned

and analyzed carefully. Performance measurement

should be based on standards similar to the CFA

Investor B

$600,000Value

C H A R T T E N

Section 1031 Property ExchangeWith Cash Payment

Investor A

$500,000Value

$100,000 Adjusted Basis$250,000

Investor A

$500,000Value

Investor B

$500,000Value

$250,000 Adjusted Basis $200,000

A and B TRADE PROPERTIES

and A pays B

$100,000

+

B Pays Tax

on $100,000Cash Receivedfrom A

(A Transfers

$100,000 Basisand adds the

$100,000Cash Paid to B)


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1 2 I RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E

Institute. At minimum, the time value of money and

carrying costs should be taken into consideration, and

a time-weighted net rate of return calculated when

comparing investment in residential real estate to

other investments.

According to Yale economics professor RobertShiller, there appears to be no continuing uptrend in

real estate prices. It is true for the United States as a

whole real home prices were 66% higher in 2004 than

in 1890, but all of that increase occurred in two brief

periods: the time right after World War II and a

period that appears to reflect a lagged response to the

1990s stock market boom Other than those two

periods, real home prices overall have been mostly flat

or declining. Moreover, the overall increase (with real

prices up 66% in the 114 years from 1890 to 2004, or0.4% a year) was not impressive.16

In addition, the real estate investor should

understand the tax aspects of any potential deal. Will

losses be deductible currently? Will depreciation be of

any current benefit? What will be the tax cost of

unrecaptured Section 1250 depreciation? An after-tax

time-weighted net rate of return should then be

calculated.

There have been, and will continue to be many

very profitable rental real estate investments, and

many investors will reap significant profits in these

investments. However, nothing is guaranteed. As

many people now realize, even ultimate capital gains

from real estate are not inalienable rights.

Successful real estate investors invest for current

positive cash flow, exclusive of any perceived tax

benefits. They seek an immediate, annual return on

their investment. In addition, they invest an inordinate

amount of time to identify properties with significant

future appreciation potential. This is accomplished byexamining hundreds of potential properties, not just

one or two.

A person who takes the time to evaluate many

properties and the expected cash flow very carefully

will increase the probabilities of profitable investing,

but even that person is not assured of positive returns.

In addition, not everyone is equipped with the

temperament to be a landlord or a home-repair

expert. That expertise can be hired, but this increases

the carrying costs of the investment. An investor inrental real estate should have significant cash liquidity

in order to weather potentially many months of the

landlords worst nightmare: no tenants. In addition,

the investor should be financially and emotionally

prepared to wait out a decline in real estate values,

such as the present housing slump.

Finally, diversification remains a prudent tenet of

successful investing. Investors should not have all

their eggs in rental real estate. They should also have

a significant portion invested in financial assets, such

as stocks, bonds, and mutual funds.

16 Shiller, op. cit., p. 20


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RE A L E S T A T E : A T A X A N D I N V E S T M E N T C R I T I Q U E I 1 3

Notes


16/16

About the Author

Cal Brown has over 20 years of experience in the financial services field. He

received his Masters of Science in Taxation at American University in

Washington, D.C. and graduated cum laude from the University of Arkansas

with a bachelors degree in Business Administration. He is President of the

Financial Planning AssociationNational Capital Area.Cal has two professional contributions published in the Journal of Financial

Planning. He has appeared on CNBC, the PBS Morning Business Report,

WAVA-FM (Washington, D.C.), and has been featured in the Wall Street Journal.

He has been quoted in Kiplingers Personal Finance magazine, U.S. News and

World Report, CNNfn, Financial Planningmagazine,Mutual Funds magazine,

and Investment News.

Cal manages all planning efforts and special projects including conducting

financial analyses for clients, is a member of the Investment Committee, and

serves as a relationship manager for many of the firms clients. Cal is responsible

for the firms operations in the Presidents absence.

Cal BrownCFP, MST

Vice President

of Planning

02 08 real estate a tax and investment critique

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