Question

A house and lot are for sale for $210,000. $40,000 is the value of the land. On January 1st, Bonnie buys the house to rent out. After 5 years, she expects to sell the house and land on December 31st for $225,000. Total annual expenses (maintenance, property taxes, insurance, etc.) are expected to be $5,000 per year. The house would be depreciated by MACRS depreciation using a 27.5 year straight-line rate with midmonth convention for rental property. For depreciation, a salvage value of zero was used. Bonnie wants a 15% after-tax rate of return on her investment. Assume that Bonnie's incremental income tax rate is 28% each year and the capital gains are taxed at 15%. Determine the following: (a) The annual depreciation, (b) The capital gain (loss) resulting from the sale of the house, and (c) compute the NPV if she charges $2000/month rent and her MARR is 15%.

Anwsers: a) year 1 1 & 5 $5925, yrs 2-4 $6181

b) $15K capital gain & $30,393 recaptured,

c) $30,871

Answer 1

a) Depreciation wil be calculated as follows -

Cost of Buildiing = $ 210000 - $ 40000 = $ 170000

Total number of years = 27.5

So, depreciation per year = $170000/27.5 = $ 6181 per year

But since it is mid month convention, Depreciation for 1st and Last year will be calculated as follows -

$ 6181 x 11.5 months /12 months = $ 5925 for first and last year.

b) Cost of House = $ 210000

Total depreciation = $ 6181 x 3years + $ 5925 x 2 years = $ 30393

Depreciated value = $ 210000 -$ 30393 = $ 179607

Sale consideration = $ 225000

Profit on sale of house = $ 225000 - $ 179607 = $ 45393

Recapture amount is equal to the total depreciation claimed = $ 30393

Therefore, Capital gain will be $ 45393 - $ 30393 = $ 15000

c) Rental income per year = $ 2000 x 12 = $ 24000

Annual maintenance expenses = $ 5000

Net rental income = $ 19000

After tax cash flows = $ 13680 for 5 years

NPV = $ 13680 x PV factor of 15% for 5 years =$ 45857