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Real Estate Investment Analysis Midterm Exam 2 Solutions - Prof. Stanley D. Longhofer, Exams of Real Estate Management

The solutions to midterm exam 2 for the re 618/890 – real estate investment analysis course, focusing on calculating taxable income, realized gains, recognized gains, and deferred gains from property sales, as well as determining depreciation allowances.

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Pre 2010

Uploaded on 08/18/2009

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Name ______________________________
RE 618/890 – Real Estate Investment Analysis
Fall 2001
Midterm Exam #2 – Solutions
Dr. Stanley D. Longhofer
T-Th 8:00-9:15
You have 1 hour and 15 minutes to complete this exam. I know its long; don’t worry, just do the
best you can in the time allotted. I would spend a few minutes looking it over before you begin;
start with the questions you know best and work on the others last. The number of points for
each question is intended to indicate how much time you should spend on each. This weighting
incorporates both the time it should take you to answer the question and its relative importance.
I’ve tried to eliminate any ambiguity about how to interpret the questions on the exam.
Nevertheless, if you make any assumptions not explicitly stated in the questions, make sure you
write them down so I can see what you are doing.
1) (5 points) Tex is a petroleum engineer in Fort Worth, but he and his wife own two rental
properties that they operate on the side. This year Tex earned $65,000 in salary and bonuses,
and his wife earned $30,000. They also took several short positions in the stock market, and
earned $35,000 in short term gains from these investments. One of their rental properties
generated positive taxable income of $10,000, while the other lost $15,000. In addition, Tex
and his wife have $10,000 of suspended losses that have carried forward from prior years.
Assume that Tex and his wife file a joint tax return.
a) What is the total taxable income Tex and his wife will report on their return for this year?
Active income $95,000
+ Portfolio income 35,000
Adjusted gross income $130,000
Passive losses $5,000
+ Suspended losses 10,000
Total passive losses $15,000
Because Tex and his wife’s active and portfolio income exceeds $100,000, their rental
real estate loss allowance is reduced by ($130,000 $100,000) 0.50 = $15,000.
Thus, they can claim $25,000 $15,000 = $10,000 of their passive losses against
active and portfolio income.
Their total taxable income for the year is therefore $130,000 $10,000 = $120,000.
b) What happens to the passive losses they are unable to use this year?
Their unused passive losses of $5,000 are carried forward to next year. If they cannot be
used then, they will continue to be carried forward until they can be used or until the
property is sold.
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_Name _______________________________

RE 618/890 – Real Estate Investment Analysis

Fall 2001 Midterm Exam #2 – Solutions Dr. Stanley D. Longhofer T-Th 8:00-9: You have 1 hour and 15 minutes to complete this exam. I know its long; don’t worry, just do the best you can in the time allotted. I would spend a few minutes looking it over before you begin; start with the questions you know best and work on the others last. The number of points for each question is intended to indicate how much time you should spend on each. This weighting incorporates both the time it should take you to answer the question and its relative importance. I’ve tried to eliminate any ambiguity about how to interpret the questions on the exam. Nevertheless, if you make any assumptions not explicitly stated in the questions, make sure you write them down so I can see what you are doing.

  1. (5 points) Tex is a petroleum engineer in Fort Worth, but he and his wife own two rental properties that they operate on the side. This year Tex earned $65,000 in salary and bonuses, and his wife earned $30,000. They also took several short positions in the stock market, and earned $35,000 in short term gains from these investments. One of their rental properties generated positive taxable income of $10,000, while the other lost $15,000. In addition, Tex and his wife have $10,000 of suspended losses that have carried forward from prior years. Assume that Tex and his wife file a joint tax return. a) What is the total taxable income Tex and his wife will report on their return for this year? Active income $95,
  • Portfolio income 35, Adjusted gross income $130, Passive losses $5,
  • Suspended losses 10, Total passive losses $15, Because Tex and his wife’s active and portfolio income exceeds $100,000, their rental real estate loss allowance is reduced by ($130,000  $100,000)  0.50 = $15,000. Thus, they can claim $25,000  $15,000 = $10,000 of their passive losses against active and portfolio income. Their total taxable income for the year is therefore $130,000  $10,000 = $120,000. b) What happens to the passive losses they are unable to use this year? Their unused passive losses of $5,000 are carried forward to next year. If they cannot be used then, they will continue to be carried forward until they can be used or until the property is sold.
  1. (15 points) Cal is selling a regional shopping center in Sacramento. According to the terms of the purchase contract, Cal will receive $350,000 cash, carry a $600,000, 2-year purchase- money fully-amortizing mortgage with 10% interest and annual payments, and the buyer will assume an existing first mortgage with an outstanding balance of $550,000. Cal’s adjusted tax basis in this property is currently $750,000, and he will incur transaction costs of 85,000. a) Calculate Cal’s total realized gain on this sale, and the amount of the gain Cal will recognize this year, next year, and the following year. First calculate the profit ratio for this transaction: Sale price $1,500,  Costs of sale 85,  Adjusted basis 750, Gross profit $665, Sale price $1,500,  Mortgage balance 550, Contract price $950, The profit ratio for this transaction is therefore $665,000 / $950,000 = 70%. The total realized gain will be the gross profit of $665,000. Next calculate the annual payment due on the note: PV = 600,000, N = 2, I = 10, P/Y = 1, FV = 0  PMT = 345, The recognized gain each year is therefore calculated as follows: 0 1 2 Payment $350,000 $345,714 $345,  Interest^1  0  60,000 31, Equity received 350,000 285,714 314,  Profit ratio 0.70 0.70 0. Recognized gain 245,000 200,000 220, Notice that the total recognized gain is equal to $665,000, the total realized gain. b) Will Cal have any other tax liabilities from this arrangement? Explain. Yes. The interest payments received at dates 1 and 2 will be taxable at the ordinary income tax rates. (^1) Calculated using the amortization worksheet or simply multiplying the annual interest rate times the balance outstanding at the beginning of the period.

d) Calculate all of the above information for Georgia. Georgia Gives Georgia Gets Property $1,200,000 Property $600,  Mortgage 900,000  Mortgage 420, Equity 300,000 Equity $180,

  • Cash boot 120, Total equity $300, Market value $1,200,000 Cash boot $120,  Adjusted basis 500,000 + Mortgage relief 480,  Transaction costs 60,000 Total boot 600, Realized gain $640,000  Transaction costs 60,  Recognized gain 540,000 Recognized gain 540, Deferred gain $100, The calculation of Georgia’s recognized gain is given on the right above. Note that she receives both cash boot and mortgage relief. Although she receives $600,000 in total boot, she need only recognized $540,000 of this because of her transaction costs. The remaining $100,000 gain is deferred. Next we calculate Georgia’s substitute basis: Market value $600,  Deferred gain 100, Substitute basis $500,  Allocation to imp. 0. Depreciable basis $400, This is depreciated over 27.5 years because the new property is an apartment property. Year 1 allowance: $400,000 ÷ 27.5  (1.5 ÷ 12) = $1,818. Year 2 allowance: $400,000 ÷ 27.5 = $14,545.
  1. (30 points) Mary is analyzing a 75,000 square foot Class-A commercial office building in downtown Baltimore. Rents in this building will be $25 per square foot (psf) next year and are expected to increase by 3% per year for the foreseeable future. The average vacancy rate for Class-A office space in downtown Baltimore is currently 10%. The operating expense ratio for this property is 45%. The tax assessor’s office currently estimates the value of the building to be $10 million, with 10% of this value attributable to land. The asking price for this property is $11.5 million, and acquisition costs are expected to be 5%. Financing is available for up to 75% of the purchase price, with a 20-year term, 7.25% interest, monthly payments, and 2 discount points. The property will be put in service on January 1, 2002. The expected holding period is 5 years (expected sale date of December 31, 2006), at which time it will be sold at an 8% cap rate (based on projected NOI for 2007). Transaction costs at the time of sale are expected to be 5% of the gross sale price. Mary will be taxed at the 28% rate on ordinary income, 25% for depreciation recapture, and 20% for long-term capital gains. a) Complete the attached Cash Flow Analysis Worksheet for years 1 and 2 for this property. to calculate NOI, cash flow before taxes, and cash flow after taxes for 2002 and 2003. See the accompanying spreadsheet. b) Complete the attached Alternative Cash Sales Worksheet to determine the sale proceeds after tax from the disposition of this property. Assume that projected NOI in 2007 will be $1,075,951. (Hint: Don’t forget to calculate the tax savings associated with unamortized loan points.) See the accompanying spreadsheet. c) If cash flow after taxes from operations will be $135,922, $152,358, and $165,813 in 2004, 2005, and 2006, respectively, what is the after-tax net present value of this investment at a 15% discount rate? What is the after-tax internal rate of return on this investment? Based on this analysis, is this a worthwhile investment for Mary? See the accompanying spreadsheet.