Private Real Estate Investment: Data Analysis and Decision Making_8

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Private Real Estate Investment: Data Analysis and Decision Making_8 159 The Tax Deferred Exchange 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. 2 The 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. 161 The Tax Deferred Exchange THE STRUCTURE EXAMPLES OF THE 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, ...