Question

(Extension of problem 2) You are still an employee of University Consultants, Limited. The investor tells you she would also like to know how tax considerations affect your investment analysis. You determine that the building represents 85 percent of value and would be depreciated over 39 years (use 1/39 per year except year 1 depreciation is also multiplied by 11.5 / 12 to adjust for the mid month convention). The potential investor indicates that she is in the 37 percent tax bracket and has enough passive income from other activities so that any passive losses from this activity would not be subject to any passive activity loss limitations. Capital gains from price appreciation will be taxed at 20 percent and depreciation recapture will be taxed at 25 percent. Because the investor works over 750 hours per year in real estate related activities, she is able to avoid the NIIT 3.8 percent surcharge. Required:

a. What is the investor’s expected after-tax internal rate of return on equity invested (ATIRR)?

b. What is the effective tax rate and before-tax equivalent yield?

d. Recalculate the ATIRR in part (a) under the assumption that the investor cannot deduct any of the passive losses (they all become suspended) until the property is sold after five years.

Answer 1

This financial question asks for the calculation of the after-tax internal rate of return on a real estate investment, considering depreciation, the investor's tax bracket, and various tax implications on investment returns. It also requests the calculation of the effective tax rate, before-tax equivalent yield, and a recalculation of ATIRR assuming suspended passive losses.

Step-by-step explanation:

This complex financial question relates to the after-tax internal rate of return (ATIRR) and involves understanding how depreciation, taxation on nominal gains, passive losses, and other tax considerations can influence investment analysis and decision-making in the context of real estate investments. The investor's tax bracket, the treatment of depreciation, capital gains tax, depreciation recapture tax, and the ability to avoid additional surcharges such as the Net Investment Income Tax (NIIT) will all impact the effective tax rate and thus the ATIRR.

Calculating the ATIRR requires a detailed analysis, taking into account the initial investment amount, expected returns, property depreciation, and the tax implications on those returns within the given tax bracket. It also involves calculating the effective tax rate by analyzing the average tax rate paid given the investment income and determining the before-tax equivalent yield, which is the gross yield that one would need to achieve the same after-tax return considering the tax effects. In part (d), the ATIRR needs to be recalculated under the assumption that passive losses cannot be deducted, which would affect the investor's returns if those losses are suspended until the property is sold.