1. must then be used to offset any capital gain from the sale of that activity
2. must ten be used to offset any other passive income produced from other passive activities during that year
3. can then be used to offset any income, including active and portfolio income earned during that year

can deduct unlimited real estate losses 

1. if more than half of all personal services they perform during the year are for real property trades or business in which they materially participate
2. if they perform more than 750 hours of service per year in those real estate activities

What are the primary benefits of investing in real estate income property?

• Net Income:  Dollars left over after collecting rent and paying expenses but before considering taxes and financing   costs.
• Property Sale:  Expecting a price increase over a specified holding period increases investor return.
• Diversification:  Reduces overall risk to hold many types of investments.
• Taxes:  Preferential tax benefits.  Taxable income is often less than before-tax cash flow.

• Expected market rents and vacancy rates
• Expenses associated with operating the property
• Nature of any leases on the property

What factors would result in a property increasing in value over a holding period?

• Inflation:  This causes rents as well as the final sale price to be higher.
• Demand:  Increased demand for space may increase value if the supply of space doesn’t increase as well.

There is less risk for the lessor with expense stops and CPI adjustments in leases.

• CPI Adjustments:The risk of unexpected inflation is shifted to the lessee.
• Expense Stops:  The risk of increases in expenses is shifted to the lessee while allowing the lessor to retain the benefit of any decrease in expenses.

Even if the investment is an existing building that has already been leased, the income can be affected when the existing leases expire and are renewed at the market rent at the time.

The investor’s initial equity in the project is equal to the purchase price less the amount borrowed.  The amount of equity an investor has in a property may change over time if the property value and loan balance changes.  E.g., if the property value increases and the loan balance is reduced through amortization, the investor’s equity increases.

What are the similarities and differences between an overall rate and an equity dividend rate?

• Difference:  The overall rate relates the entire NOI to the value of the property.  The equity dividend rate relates the BTCF (or equity dividend) in the first year to the initial equity investment.
• Similarity:  Neither one of these is a measure of investment yield because they do not take into account future income from operations or resale of the property at the end of the holding period.  Both are based on a single year, usually the first year. 

What is the significance of a debt coverage ratio?

It is a ratio of the NOI to the mortgage payment that indicates the riskiness of a loan.  It is the degree to which the NOI from the property is expected to exceed the mortgage payment.  Lenders typically want a debt coverage ratio     (DCR) to be at least 1.2.

What is meant by tax shelter?

The term “tax shelter” refers to an investment that allows a taxpayer to reduce taxable income.  Although most of the tax shelter benefits of real estate were removed by the Tax Reform Act of 1986, depreciation deductions still provide some “shelter” in that they are non-cash deductions that reduce taxable income.  Interest deductions on the mortgage also serve to reduce and in a sense shelter taxable income.

How is the gain from the sale of real estate taxed?

The entire taxable gain from the sale of real estate is taxed at the same rate as ordinary income.

            It is still important to keep track of capital gains/losses and ordinary income gains/losses.  This is due to TRA rules for passive investors and properties acquired prior to 1986.

An effective tax rate is a tax rate that takes into account the effects of depreciation and time value of money.

It measures the actual difference between the BTIRR and the ATIRR.  This difference is the effective tax rate and can be less than the actual marginal tax rate.

 This difference is also due to the fact that the interest on the mortgage loan is deductible.

Yes.  Not all investments are treated alike when it comes to federal income taxes.  Thus, taxes must be considered when comparing returns for investments which are not taxed in the same manner.  Investments that have the same before-tax return may have quite different after-tax returns.

The PALL rules are important because, in general, passive losses cannot be used to offset income from another category.  Because any tax loss from real estate is usually considered a passive loss,  it can not be used to offset income from other sources such as active income from salaries and wages or portfolio income from interest or dividends.