Question

A multi-family property is for sale with an asking price of $2.75 million. You have been asked to conduct an analysis on a potential purchase of this property, based upon various assumptions, and using a 5 year investment horizon. The property is assumed to increase in value by 3.5% per year and be sold at the end of year 5 for that exact price. Year 1 gross rents are estimated to be $280,000 and to increase at 4% per year. Vacancies and collections are estimated at 8% of gross rents. Operating expenses are estimated to be 35% of Effective Gross Income (Gross rents less vacancies/collections). The purchase will be financed through a loan with a 75% LTV, a 30 year term and an interest rate of 5.25% - the loan will be interest only, no principal amortization. For depreciation purposes, 80% of the purchase price is attributable to the property structure with the balance attributed to land. Multi-family properties are depreciated over a 27.5 year life.

Factoring in both interest and depreciation (which are both tax deductible), what would be your Year 1 taxable income?
a. $139,159
b. $195,721
c. $355,721
d. ($20,841)

Answer 1

The Year 1 taxable income when accounting for interest and depreciation would be a loss of $20,841.25, after calculating gross rents, effective gross income, operating expenses, interest expense, and depreciation.

Step-by-step explanation:

To calculate the Year 1 taxable income from the purchase of a multi-family property, we start with the estimated gross rents of $280,000. The effective gross income (EGI) is then determined by subtracting 8% for vacancies and collections, which gives us $257,600 (92% of $280,000). Operating expenses are 35% of this EGI, leading to $90,160 (35% of $257,600). We then apply the loan's interest and depreciation to find resulting taxable income.

To determine the interest expense, we multiply the loan amount ($2,062,500, which is 75% of $2.75 million) by the interest rate of 5.25%, resulting in $108,281.25 Paid Annually. For depreciation, we take 80% of the purchase price as depreciable property structure, resulting in $2,200,000 worth of structure. This is depreciated over 27.5 years for an annual depreciation deduction of $80,000.

Now, we can find the taxable income as: EGI - Operating Expenses - Interest Expense - Depreciation = $257,600 - $90,160 - $108,281.25 - $80,000 = -$20,841.25.

Therefore, the direct answer in 2 lines is: The Year 1 taxable income, factoring in interest and depreciation, would result in a loss of $20,841.25.