real estate chapter 20 tools & techniques of investment planning copyright 2007, the national...

Real Estate Chapter 20Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• Real estate is land and the buildings and improvements on land.– By definition, real estate includes natural assets, such as

minerals, under the land.– Because of the obvious limited supply of land, especially in

“desirable” locations, real estate has long been viewed as an attractive investment alternative.

• Real estate can be classified into four major categories:– Land– Residential– Commercial– Industrial


Investment Planning


What is it?

• Land– Unimproved– Farm land– Recreational– Ranches– Subdivided lots

• Residential– Single family dwellings– Multiple family dwellings

• Apartments and condominiums

– Hotels and motels


Investment Planning


What is it?

• Commercial– Residential rental– Office buildings– Retail stores– Shopping centers– Specialty buildings

• Industrial– Factories– Warehouses– Industrial parks– Utility facilities


Investment Planning


When is the use of this tool indicated?

• When an investor desires an investment with tax shelter potential

• When a long-term hedge against inflation is needed• When a relatively constant cash flow is required• When an investor is looking for long-term appreciation• When the investor would like a tangible investment• When the investor wants to make maximum use of

leverage– Lenders are willing to advance large sums of money on the

security of real estate for long periods of time at relatively low interest because real estate is not only tangible and stationary, but is also reasonably stable in value


Investment Planning


Advantages

• Real estate has numerous different tax related advantages:– Expenditures that are considered ordinary and necessary in the

production or collection of income or in the preservation of its value as an investment are deductible.

– The cost of supplies, labor, and other components necessary to keep the property in good repair can be deducted.

– Real estate property taxes are deductible.– A tenant leasing business property may deduct reasonable

rental costs.– Interest on the unpaid balance of the mortgage is deductible– The full cost of buildings and real estate improvements is

depreciable.


Investment Planning


Advantages

– Gain on the sale of real estate can be reported over more than one tax year.

• This may allow the investor to defer the payment of tax until cash proceeds from an “installment sale” of the property are received

– Losses incurred on the sale of real estate are deductible.– One parcel of real estate can be exchanged for another without

immediate recognition of income.• Tax-free exchange rules

– Upon the “involuntary conversion” of real estate, the investor does not have to pay any tax upon the receipt of cash from insurance or condemnation award.

• So long as the cash is reinvested in “qualified property” having equal or greater value


Investment Planning


Advantages

– Liquidity can be obtained from real estate without paying taxes through a mortgage on the property.

– The cost of rehabilitating certain buildings or structures may qualify for a special investment tax credit.

– “Passive activity” tax rules• Limit the ability to use real estate losses to offset income from other

sources


Investment Planning


Advantages

• Real estate is tangible.• Real estate has historically proven itself as an excellent

hedge against inflation.– It tends to increase in value while prices are rising and the

value of the dollar is declining.• Each parcel of real estate is unique.

– Because no two parcels can share the same location, no two can be exactly alike.

– The “monopoly” each real estate owner has on each individual location is itself of value.

• Because of its great value as security for a loan, real estate enables an investor to obtain maximum potential leverage.


Investment Planning


Disadvantages

• Real estate is almost always relatively illiquid.– Difficult to convert to cash quickly

• Some degree of management is necessary with all real estate investments.

• Typically the investment in real estate is large in amount.– Requires the commitment of investable funds for a long period

of time.


Investment Planning


Disadvantages

• Costs related to the purchase or sale of real estate reduce its value as an investment that can produce a short-term gain.– Include transfer taxes, title insurance, appraisals, financing

fees and “points,” title recording and notary fees, and sales commissions

– May run as high as 10–15%

• Real estate, by definition, cannot be moved.


Investment Planning


Disadvantages

• Once land has been improved with a building, that “improvement” is often difficult and expensive to modify or remove.– Referred to as “fixity” of investment.

• It is often difficult or impossible to assess the economic risks and projected return on a real estate investment with exactness.

• Because the investment return on real estate is significantly affected by the available tax benefits, such investments are most susceptible to the risk of challenge by the IRS.


Investment Planning


Tax Implications

• All the ordinary and necessary expenses paid or incurred by a real estate investor during the taxable year in carrying on a trade or business are deductible.– Include costs incurred in the production or the collection of

investment income, as well as expenditures for the management, conservation, or maintenance of real estate property held either to produce income or for appreciation

• Routine repair and maintenance expenses (those that do not appreciably add to the value of the property) are deductible in the year the outlay is incurred.– The cost of improvements must be capitalized.

• Added to the investor’s basis in the property• Recovered through depreciation deductions


Investment Planning


Tax Implications

• Amounts paid for real property taxes are deductible when paid.– Construction period taxes must be capitalized and then amortized.

• Rental expenses for the use of business property are deductible currently.

• Interest paid to finance the purchase of investment real estate may be deductible currently.– Rules may limit the deductibility of:

• Construction period interest• Investment interest• Prepaid interest• Points• Passive losses / “At risk” rules


Investment Planning


Tax Implications

• Land is not depreciable– Improvements upon the land are eligible for depreciation deductions.– Tax losses from depreciation deductions are subject to the “passive

activity” rules.

• Tax on the gain upon the sale of real estate can be deferred.– “Installment sale rules” permit an investor to delay reporting any gain

or paying any tax until money is received.• The law does not set a limit as to how long the parties can agree

to extend the payment period.• Tax law expects that the parties will provide for interest on the loan

inherent in an installment sale.


Investment Planning


Tax Implications

• Losses on the sale of real estate held for investment or used in a trade or business are generally deductible in the year incurred.– Losses incurred on the sale of personal use realty are not

deductible.– Real estate held purely for investment is treated as a capital

asset.• Subject to capital gain / loss rules

– Real property used in a trade or business is not a capital asset.• If held for the long-term holding period before being sold,

such property is called “Section 1231 Property.”– Capital gain or ordinary loss


Investment Planning


Tax Implications

• “Like-kind” exchange– Under certain circumstances, it is possible for an investor to

trade/exchange properties with another party and postpone all or part of the gain that would normally have to be recognized on a sale.

• Tax deferral may also be available upon “involuntary conversion.”– Involuntary conversion is the destruction of property by fire or other

casualty.– It may also be caused by the condemnation of property by a

governmental body utilizing its right to take private property and convert it to the use of the public.

– Any gain realized can usually be deferred if the investor reinvests the full proceeds in similar property within three years from the end of the year in which the proceeds are received.


Investment Planning


Tax Implications

• An investor can convert part of the appreciated value of property into cash without either selling it or otherwise triggering a tax on any gain.– Use property as security for a loan

• The cost of constructing or rehabilitating certain building or structures may qualify for a special investment credit.– The properties eligible for this credit include:

• Qualified low income housing

• Certified historic structures

• Buildings that were first placed in service before 1936


Investment Planning


Alternatives

• Few investments are comparable to real estate because of its unique characteristics, location, potential for significant tax shelter benefits and relatively constant cash flow, and psychological comfort.– Other investments, such as stocks, do provide a long-term hedge

against inflation, the possibility of substantial appreciation, and the potential to maximize the use of leverage.


Investment Planning


Where and How do I get it?

• An individual will typically purchase real estate in his own name directly from the seller or through a real estate broker or agent.– Most real estate acquired for tax shelter purposes is acquired

by purchasing an interest in a partnership or other investment entity.


Investment Planning



• Real estate may be held by an investor in any of the following forms:– Outright ownership– General partnership or joint venture– Limited partnership– Corporate (C corporation)– S corporation– Real estate investment trust (REIT)


Investment Planning



• Outright Ownership– Does not protect the individual investor from full personal

liability relating to the ownership and operation of the property– Full management responsibility– All tax benefits and costs are personal to the investor– An outright owner can convey the title to all or a portion of the

property at any time without restriction– Death results in the termination of the individual ownership

form• The property will then pass through the investor’s estate to

his heirs or by operation of law to his joint owners.


Investment Planning



• General Partnership– Two or more individuals join together for investment purposes

• General partner jointly and severally liable for all the debts and obligations

– If a partner cannot pay his part of the obligation, the remaining partners are liable.

• Usually only a few partners are actively involved in operations– Not taxed as separate entities

• Income, deductions, and credits flow through to the partners– Losses deductible only up to basis in partnership

• Right to transfer interest in property is limited to the terms of the partnership agreement

– Death of a partner may cause termination of the partnership unless the partnership agreement provides otherwise


Investment Planning



• Limited Partnership– Limited liability for “limited partners”– Most are heavily leveraged

• Limited partners not at risk: may not be able to deduct partnership losses

– Limited partners cannot take part in management• Vested solely in the general partner

– Income, deductions, and credits flow through to the partners according to their proportionate ownership


Investment Planning



– Right to transfer interest in property is limited to the terms of the limited partnership agreement

• More restrictive than partnership agreements

– Death of a partner will not cause the termination• Heirs succeed in interest

– Syndicated partnership• Syndicator-promoters

• Investors


Investment Planning



• Corporations – Limited liability

• C or S corp• Full liability stops with the corporation• Corporate borrowing

– Personal guarantees– Centralized Management

• Board of directors elected by shareholders– Does not terminate at death of shareholder

• Indefinite life– Enhanced transferability

• Shareholder can transfer any number of shares– Restricted on S corp

– C corporation is a separate legal entity• Must file its own tax return• Corporate earnings paid to shareholders taxed twice


Investment Planning



• S Corporations – Treated essentially the same as a C corporation except for

taxation• Taxed similarly to a partnership

– May not have more than 100 shareholders• All individuals or trusts• No nonresident aliens• Not more than 1 class of stock


Investment Planning



• REITs (Real Estate Investment Trust)– A vehicle specifically designed to facilitate large-scale public

participation in real estate investments.– Operates similarly to a mutual fund– Having many investors, each contributing relatively small

amounts of capital, enables the management of the REIT to make diversified and large-scale investments on their behalf.


Investment Planning


What fees or other costs are involved?

• Broker’s commissions• Legal fees• Title examination and registration fees• Title insurance• State and local transfer taxes• Syndicated real estate venture

– Higher costs of investing than an investment where the owner finds, develops, and manages the property because these responsibilities are assumed by the developer/promoter.

– 16% to 26% of the amount invested– In a private offering, total costs range from 13% to 25%.


Investment Planning


How do I select the best of its type?

• Location of the property• Soundness of construction and appropriateness of design

for intended use• Cost of capital• Financing fees• The cost of operating and maintaining the property• Organization and offering expenses• Sales commissions• Construction costs• Fees paid to the general partner for managing the

partnership and the underlying investment property• Projected cash flow and tax results from operations


Investment Planning


Where can I find out more about it?

• Tax Facts on Investments• Tax-Advantaged Investments• Tax Planning for Investors• The real estate industry offers many educational

programs and courses:– The National Marketing Institute of the National Association of Realtors– The Certified Commercial Investment Member designation– Member of Appraisal Institute– Farm and Land Institute– Graduate of Real Estate Institute– Certified Residential Broker