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The Tax Deferred Exchange 159 Most of academic finance and economics ‘‘assumes away’’ the complication of income taxes. This can frustrate the reader who knows that taxes are a reality and usually affect one’s decisions. In defense of academics, it should be noted that working with U.S. income tax rates is frustrating. The code is a moving target. Working with graduated tax rates requires use of a step function, a rather inconvenient mathematical device. As this chapter deals directly with taxes, we may not assume them away lest the entire subject disappear. However, some assumptions are necessary in the interest of simplicity. One of these is a flat tax rate. The alert reader knows that U.S. income tax rates change with income levels, but our conclusions here will not change by relaxing the flat tax assumption. There are lessons for readers outside the United States. First, Section 1031 has been in the U.S. tax code since its inception. Congress intended citizens have the right to defer tax on gains when transferring from one location to another while remaining in the same business. This fosters important incentives that contribute to the development of society. Second, taxation policy affects behavior. The U.S. tax code in its present form is not a work of art. Even the administration of Section 1031 transfers has become needlessly complicated under the guise of ‘‘simplification.’’ Policymakers in other countries may wish to proceed with caution before following the U.S. model. Recent amendments to Section 1031 have had unintended consequences that influence the market. A primary justification for ignoring income taxes in other writings is that all economic agents operate in a common income tax environment. The marginal difference in tax brackets spanning different ranges of income certainly affects the accuracy of any particular calculation, but these may be viewed as de minimus. The central message of this chapter is that some capital gain taxes may be delayed and some may actually be eliminated. This is a more powerful effect than one of merely assuming all taxpayers are not taxed or taxed at the same rate. Indeed, the point of this chapter is that some taxpayers holding particular assets and transferring them in certain ways may reduce, delay, or eliminate some taxes altogether. Organized around a set of stylized examples, this chapter explores not only the obvious benefits of exchanging, but some of the less obvious disadvantages of a poorly thought-out exchange strategy. We will take the usual approach to determine if the benefits exceed the costs. Given that the investor has entrepreneurial abilities and tendencies, we will look at: The value of tax deferral three ways: (1) in nominal dollar terms, (2) as a percentage of the capital gains tax due on a normal sale, and (3) as a percentage of the value of the property to be acquired 160 Private Real Estate Investment The effect of tax deferral on risk The cost of exchanging, not just the hard costs, but implicit costs often overlooked The alternatives of sale and repurchase, refinance, or simply hold for a longer period Examples in this chapter build on earlier examples. In a complex world it is important to be able to isolate the most important variables on which investment decisions rest. As we move through the exchange strategy, we retain the burdensome minutiae that we labored over in earlier chapters. But as many of those calculations involve nothing new, having mastered them in earlier chapters, we now put them out of view. For instance, real estate is usually financed with self-amortizing financing. There is no reason to have the loan amortization calculation in the forefront of our present discussion. Exchange or no exchange, loans are a fact of life, and their amortization is not mysterious. The same can be said for depreciation, sale proceeds, and capital gain calculations. All of these are computed with fairly simple algebraic equations that need not be at center stage with the more important concept of the tax deferred exchange. VARIABLE DEFINITIONS The examples in this chapter are similar to those in Chapter 4 describing basic investment analysis.2 For pedagogical reasons we included a number of variables in Chapter 4 that are not needed here. For example, because operational variables prior to net operating income are mathematically trivial, they have been ignored here so that all examples in this chapter begin with net operating income (NOI). The list of variables used in this chapter has considerable overlap with that in Chapter 4 to which we add variables that permit growth rates to be different in different years. lc ¼ logistic constant when using the modified logistic growth function af ¼ acceleration factor when using the modified logistic growth function The electronic files that accompany this chapter provide a fully elaborated set of examples in Excel format. 2The important difference is that in Chapter 4 value is a function of a market rate of growth. Here value is a function of both income growth and capitalization rate. The effect and importance of this difference is illustrated in the electronic files for this chapter. The Tax Deferred Exchange 161 THE STRUCTURE OF THE EXAMPLES The examples illustrating the ideas in this chapter are organized as follows. 1. The Base Case: Purchase–Hold–Sell. An initial ‘‘base case’’ (base) is examined to provide background and context. In the base case the investor merely purchases, holds for six years, and sells a single property. During the holding period the value grows mono-tonically. 2. Example 1: Modifying the Growth Projection. Example 1 (dataEG1) deviates from the base case only by introducing the idea of growth at different rates over different time periods (the logistic growth idea discussed in Chapter 4) during the six-year holding period. 3. Example 2: The Tax Deferred Exchange Strategy. The second variation from the base case involves two properties (dataEG2a and dataEG2b) that are each held for three years in sequence. The second property is acquired via exchange of the first property. Thus, the ownership of the two properties spans the same time period as Example 1. Each property grows in value under the same conditions as those assumed for dataEG1. 4. The Sale-and-Repurchase Strategy: Tax Deferral as a Risk Modifier. The outcome of the exchange strategy is then contrasted with the results achieved via the taxable sale of the first property (dataEG2a) at the end of year three, the purchase of the second property (dataEG2c) with the after-tax proceeds of the sale of the first, and concluding with the taxable sale of the second property at the end of three more years (again a total of six). 5. The Sale-and-Better-Repurchase Strategy: The Cost of Exchanging. The sale-and-repurchase strategy portion of Example 2 is re-examined (dataEG2a and dataEG2d) using a lower price for the second purchase, presumed to be achieved with superior negotiation following the taxable sale of the first property. This addresses the question of how much price discount is needed upon acquisition of the second property to offset the value of tax deferral if exchanging is not an option. 6. Example 3: Exchanging and ‘‘the Plodder.’’ In the last variation (dataEG3a and dataEG3b) we repeat the same analysis as in Example 2, but return to the monotonic growth of the base case. We then compare the exchange outcome under those conditions with the sale and purchase alternative (dataEG3a and dataEG3c). Finally, we return to the base case assumptions to consider a longer term, 12-year buy-and-hold strategy of a single property. 162 Private Real Estate Investment Each example and variation illustrates a different strength or weakness of holding, selling, exchanging, and/or reacquiring property. THE BASE CASE: PURCHASE–HOLD–SELL Data for our base case project is entered in Table 7-1, followed by the rules of thumb measures in Table 7-2. The final year of the multi-year projection is shown in Table 7-3. For the terminal year reversion, we need calculations TABLE 7-1 Base Case Inputs dp noi txrt dprt land cro g lc af $360,000 $119,925 0.35 1 27.5 0.3 0.0936 0.03 0 0 i initln t r k scrt cgrt recaprt ppmt units .095 12 $875,000 360 0.13 6 0.075 0.15 0.25 0 22 TABLE 7-2 Rules of Thumb Capitalization rate Price per unit Cash-on-cash return Debt coverage ratio Loan-to-value ratio 0.0971 $56,136 0.0824 1.36 0.7085 TABLE 7-3 Terminal Year Operating Performance Net operating income Debt service Depreciation Income tax After-tax cash flow $139,025.94 $88,289.70 $31,436.40 $9,785.96 $40,950.30 The Tax Deferred Exchange 163 TABLE 7-4 Terminal Year Equity Reversion Sale price Beginning loan balance Ending loan balance Original cost Sale costs Accumulated depreciation Capital gain Capital gains tax Pre-tax net equity After-tax net equity $1,474,655 $875,000 $833,449 $1,235,000 $110,599 $188,618 $317,674 $66,513 $530,607 $464,094 TABLE 7-5 Base Case Net Present Value and Internal Rate of Return Base case NPV $557 IRR 0.130351 made at the time of sale, shown in Table 7-4. The npv and irr results for the base case are shown in Table 7-5. It is important to point out that the IRR in Table 7-5 is the after-tax IRR. Graphically, in Figure 7-1, we see the components of the sale proceeds in the base case. This sets the scene for the primary purpose of this chapter, which is to examine the ramifications of NOT having to pay capital gains tax. The Base Case represents a quite standard discounted cash flow (DCF) analysis with monotonic growth over a fixed holding period terminating in a taxable sale. Next, combining the modified logistic growth function described in Chapter 4 with the exchange strategy, we relax some of these assumptions. EXAMPLE 1—MODIFYING THE GROWTH PROJECTION First, we modify our data to reflect the entrepreneurial growth associated with an early transformation period. Note that in the base case data the variables for the logistic growth curve, lc and af, were zero. In Table 7-6 we see that in ... - tailieumienphi.vn