PRECIOS

You do not want to hold the mortgage because, at this inflated price, Walter may have difficulty servicing the debt with the current revenue. A third-party lender would show no less reluctance to underwrite the loan unless Walter makes a substantial down payment (and thus takes out a relatively small loan). For more information on these topics, see the chapters on debt coverage ratio (Part II, Calculation 23) and loan- to-value ratio (Part II, Calculation 26).

His offer represents a cap rate of 8.57%, substantially less than what he should be able to achieve in this market.

17

Calculation 12:

Taxable Income

What It Means

A property’s taxable income is exactly what its name suggests: the amount on which you must pay Federal income tax. Perhaps it would be more help- ful to identify what taxable income is not: It’s not your total rental income, not your income after operating expenses (i.e., NOI), and not your cash flow.

Taxable income in regard to real estate, like taxable income in the rest of your life, is whatever the tax code says it is. Fortunately, for purposes of this discussion, while there have been minor tweaks from time to time, the definition as it applies to real estate has remained basically constant. It’s reasonable to believe that what you learn here will still be useful after the ink is dry.

Like cash flow, taxable income does begin with the property’s revenue minus operating expenses, what you have come to know as the net operat- ing income (NOI). From that point—and unlike cash flow—the NOI is then reduced not by everything you spend, but rather by everything the current tax code allows you to deduct. For example, you cannot deduct your entire mortgage payment, but you can generally deduct the entire interest portion. If you revisit the discussion in Part I, Chapter 4, you’ll recall that you can also deduct depreciation and amortization. When you buy an invest-

ment property, you can’t just take its purchase price as a tax deduction. You can, however, take the portion of the purchase price that represents the buildings (not the land) and write that portion off over what the tax code prescribes as its “useful life.” This write-off is called depreciation. If you make an addition or capital improvement to the property, that too is written off through depreciation and not as a one-year tax deduction.

Another item that must be deducted over time instead of when it is actu- ally spent is the premium you pay for obtaining a mortgage, called “points.” If you get a 240-month mortgage, you will generally deduct the loan points over that period. Similarly, closing costs such as legal fees to acquire an investment property must also be written off over time, usually the same number of years as the property’s useful life. You’ll refer to the process of taking a partial annual tax deduction for an item that cannot be expensed in a single year as “amortization.”

Finally, keep in mind that you must also count as taxable income any interest earned on property bank accounts or mortgage escrow accounts.

How to Calculate

Top-down calculation:

Net Operating Income less Mortgage Interest

less Depreciation, Real Property less Depreciation, Capital Additions less Amortization, Points and Closing Costs plus Interest Earned

Taxable Income

Let’s look at the component parts. As you’ve seen before, NOI equals gross scheduled income less vacancy and credit loss less operating expens- es. It’s your collected income less operating expenses.

Unless you have an interest-only loan, your mortgage payments are made up of both interest and principal. Only the interest portion is deductible.

You can claim depreciation deductions based on the purchase price of the buildings and on the cost of capital improvements. The cost of new

improvements is certainly unambiguous, but allocating the property’s pur- chase price between land and buildings requires a judgment call on your part. The most common and defensible approach is to use the proportions that you find in your assessments for local property tax. If the town or city assesses your property’s land at $25,000 and its buildings at $75,000, then regardless of what you paid for the property, you should be able to assume that 75% of the purchase price went to pay for the buildings.

The useful life of the buildings is specified in the tax code. As of this writ- ing, you depreciate residential property over 27.5 years and nonresidential over 39 years. Also in the current law is the “half-month convention,” which says that you can take only one-half month of depreciation in the month that you place a property into service, and one-half in the month you dispose of it. By current rules, you must amortize closing costs associated with the acquisition of an investment property over the same useful life that you use for depreciation purposes. Your normally do this by adding the amount of the closing costs to the property’s depreciable basis.

The rules regarding depreciation may change at any time the Congress feels like giving more or less benefit to real estate investors.

Capital additions (additions having a useful life of more than one year or improvements that are likely to prolong the life of the property) are treat- ed the same as the main property. You typically depreciate them over the same useful life, starting when they are placed in service. The half-month convention applies to these as well.

You will amortize loan points over the number of months of the loan term. It is not unusual for a commercial mortgage to have its payment based on a relatively long term, such as 180 to 240 months, while at the same time requiring a “balloon payment” (i.e., a payoff of the outstanding balance at a much earlier date). In such a case, the balloon payment marks the term of the loan for purposes of amortizing the points. For example, say that you have a loan whose monthly payment is based on 240 months; but the loan also requires that you pay it off in full at the end of 60 months. You can amortize any loan points over the 60 months.

The last of the components is interest income. This is usually not included as part of the NOI because it does not derive from the operation of the property. Nonetheless, if you have property bank accounts or mort- gage escrow accounts that pay you interest, you must add that to your prop- erty’s taxable income.