Question

An investor is considering buying a rental duplex with land valued at $30,000 and the building valued at $150,000. Straight-line depreciation over 27 ½ years will be taken. The investor will be actively involved in the management of the property. He is in a 30% tax bracket.

Assume potential gross income of $44,000 in year one, vacancy of 12% and Operating expenses equal to 40% of Effective gross income. Gross potential income is expected to increase by 2% each year over the holding period.

A lender will make a 20-year loan equal to 75 percent of the total value of the property at 9 percent interest with monthly payments. Assume that there is 3 percent inflation related to total property value each year the investor owns the property and that there is a 4% commission paid (selling expenses) in the year of sale.

Assume that the investor’s after tax required rate of return is 12% and will hold the property for three years. Use the 25% tax rule where: for capital gain -- (tax rate >25% use marginal tax rate of 15%); for depreciation recapture-(tax rate >25% use marginal tax rate of 25%).

What is the after tax cash flow from sale of the asset in year three.

Answer 1

Calculation of after tax cash-flow from sale of the asset in year three:

Step 1: Calculation of property value at end of year 3 & loan outstanding at end of year 3

Workings:

Step 2: Calculation of after tax cash flow from sale of the asset in year three

After tax cash-flow at the end of year 3 is $54,272.

Workings:

Note:

1. Tax on capital gain considered at 15% since the investor is in 30% tax bracket (25% tax rule where: for capital gain -- (tax rate >25% use marginal tax rate of 15%))

2. Tax on depreciation recaptured at 25% since the investor is in 30% tax bracket (25% tax rule where: for depreciation recapture-- (tax rate >25% use marginal tax rate of 25%))

3. Since the investor is selling the property at year 3, the outstanding principal on loan taken needs to be repaid and hence deducted above from net sale price.

4. Interest on loan considered to have already paid for year 3

5. Depreciation on property is considered to have been availed for year 3 before the sale of property

6. Apart from sale of asset, the investor will also have operating cash-flow at year 3 of $8,932 as follows:

Thus, the total cash-flow for year 3 (operating + sale of property) is $8,932+$54,272 = $63,205.

Workings:

Yearly interest computation: