Comparing the income property values of low- and high-income taxpayers.
This article explores some of these relationships, especially that between the annual growth rate of property values and the individual tax rate. The comparisons are made on both residential and nonresidential income properties, and the effect of the Taxpayer Relief Act of 1997 (TRA)(1) is addressed.
The TRA had a major effect on the taxes paid by individuals and affects property values because of changes made in market-specific inputs. The TRA reduces the top capital gains rate from 28% to 20% for taxpayers in high-income brackets, and from 15% to 10% for taxpayers in low-income tax brackets. (The capital gains rate is zero if the taxpayer is not paying taxes.) The agreement calls for the top capital gains rate to drop to 18% in the year 2006 for investments held for at least five years. Those in the lower tax brackets would have to pay only an 8% capital gains rate on investments held for at least five years. The 8% begins in 2001. (The tax rate for a high-income taxpayer is 25% on the recapture of depreciation, while the regular tax rate is used for the recapture of depreciation for a low-income individual.)
In this study, low-income taxpayers are individuals with a marginal tax rate less than or equal to 15%; all others will be classified as high-income taxpayers. The TRA's effect on estimated residential and nonresidential income property values will be evaluated, using the Bouillon and Karney after-tax cash discount model, which is based on a previous study (see appendix).(2) It is assumed that an increase in capital gains exclusion (reduced capital gains rates) should lead to an increase in value of residential income property. Consequently, the TRA should cause an increase in the estimated income property values (see table 1). By using the input values from a numerical example and a marginal tax rate of 39.6% we show that the estimated residential and nonresidential income property values would change by approximately 5.47% and 4.85%, respectively. Holding the property for five years would affect estimated residential and nonresidential income property values by an additional 1%. The general tax rate of investors in real estate investment trusts (REITs) could strongly affect market-specific input values due to the dollar volume of property that REITs own.
The following numerical example provided the specific input values in the income property valuation model:
* The current marginal tax rates that individuals pay are 0%, 15%, 28%, 31%, 36%, and 39.6%.
* A 30-year, 8% mortgage is used for 80% of the property value.
* The typical holding period is 10 years.
* The first-year net operating income before the deduction for interest and depreciation (N) is forecast at $6,000. This value is expected to grow at a rate of 2% per year.
* The value of the property is anticipated to increase at an annual rate of 4%.
* Land represents 20% of the total market value.
* Selling expenses are expected to be 7% of the selling price.
* The expected yield rate is 12%.
* The purchase of the property is assumed to take place in January. The property will be sold in December of the 10th year.
[TABULAR DATA FOR TABLE 1 OMITTED]
The straight-line depreciation for real property would be based on the depreciation life of the property. The applicable percentages for depreciation on residential and nonresidential income properties are presented in table 2.
The TRA's potential effects can be shown by estimating the market value separately for the previous and new law for residential and nonresidential income properties. The estimated market price for residential income property under the previous law is found by substituting the market-specific inputs into the model.
TABLE 2 Applicable Percentage for Depreciation Years [Percentage.sup.c] Life = 27.5 years(a) 1 3.485 2-9, 11, 13, ..., 27 3.636 10, 12, 14, ..., 26 3.637 28 1.970 Life = 39.0 years(b) 1 2.461 39 2.564 40 0.107 a TMI Tax Service, Inc., income Tax and Financial Planning QuickFinder[TM] Handbook Form 1040 1988 Edition-1997 Tax Year (Minnetonka, Minnesota: TMI Tax Service, Inc., 1997), 10-2. b TMI Tax Service, Inc., Income Tax and Financial Planning QuickFinder[TM] Handbook Form 1040 1988 Edition-1997 Tax Year (Minnetonka, Minnesota: TMI Tax Service, Inc., 1997), 10-1. c These percentages are for straight-line depreciation for read property assuming mid-month convention.
First, market values for residential and nonresidential income properties were estimated by changing the annual growth rates in property values (G) from 0% to 8%. Table 3, which presents the estimated market values for all six individual tax rates, illustrates that a low-income [TABULAR DATA FOR TABLE 3 OMITTED] taxpayer would be willing to pay more than a high-income taxpayer when the annual growth rate of property values (G) is small. This would be true for both residential and nonresidential income properties. The indifference point for G varies greatly from 5.9% (7.6%) to 1.6% (3.1%) when measuring residential (nonresidential) income property values. This table also indicates a wide variation within a high-income taxpayer. The indifference point for G on residential (nonresidential) income property is 1.6% (3.1%) when an individual in the 28% tax bracket is compared to another in the 39.6% bracket.
This means that if properties are appraised using a marginal tax rate of 28%, taxpayers in the 39.6% tax bracket may be reluctant to enter the residential (nonresidential) income property market unless the annual growth rate in income property values is greater than 1.6% (3.1%).
Table 4 presents similar values for low- and high-income taxpayers using market-specific input values. After the TRA was passed, the principal change that this table shows is the reduction of the indifference points of G. For example, the indifference point of G for residential income properties, assuming a comparison between 15% and 39.6% taxpayers, declines from 4.1% to 2.8%.
While the TRA has led to lower indifference points, the reduction is more significant [TABULAR DATA FOR TABLE 4 OMITTED] when low- and high-income taxpayers are compared. The indifference point only decreases slightly between 28% and 39.6% taxpayers. Therefore, there is less incentive for low-income taxpayers to invest in income properties. In addition, high-income taxpayers (especially individuals in the 39.6% bracket) would enter the income property market when the annual growth rate of property values is lower.
The first significant finding of this study is that the TRA should increase estimated property values. According to the numerical example, that increase was estimated to be approximately 5%. If the property is held for at least five years, an additional 1% increase is expected.
Second, there is a change in estimated appraised values due to changes in the annual growth rate of property values (G). It was determined that at the lower levels of this growth rate, low-income taxpayers would be willing to pay a larger amount than high-income taxpayers for the same property. High-income taxpayers are willing to pay more than lower taxpayers as the growth rate increases. When the TRA was incorporated, the willingness of low-income taxpayers to invest in income-producing properties diminished. Meanwhile, the high-income taxpayer had more incentive to enter the income property market.
Finally, within the high-income taxpayer group, it was determined that there is a difference in values at different growth rates. Therefore, at higher growth rates, a 39.6% taxpayer would be willing to invest a larger amount than a 28% taxpayer, indicating that income property should be appraised using 28% when below the indifference point, and 39.6% when above it. Therefore, as shown in table 4, the appraised value of a residential income property when G = 1% would be approximately $69,539, and when G = 4%, would be approximately $96,477.
1. Taxpayer Relief Act of 1997, PL 105-34.
2. A traditional spreadsheet approach was employed to double-check the estimated values. See Marvin L. Bouillon, "The Effects of Capital Gains Exclusions and Income Tax Rates on Residential Income Property Values," Real Estate Finance (Spring 1991), 93-98.
Albert, J. D., and W. C, Weaver. 'A Model for Analysis of the Components of Equity Value: Will Changes in the Tax Law Affect Market Values?," The Appraisal Journal (January 1986): 109-117.
Bouillon, Marvin L., and D. F. Karney. "The Ellwood Valuation Model Using After-Tax Cash Flows," Real Estate Finance (Spring 1990): 84-90.
Brueggeman, W. B., and J. D. Fisher. Real Estate Finance and Investments, 9th ed. Homewood, Illinois: Richard D. Irwin, Inc., 1993.
Frederick, B. J. "Effect of Proposed Tax Law on Investment Real Estate," The Appraisal Journal (April 1986): 266-273.
TMI Tax Service, Inc. Income Tax and Financial Planning QuickFinder[TM] Handbook Form 1040 1988 Edition-1997 Tax Year. Minnetonka, Minnesota: TMI Tax Service, Inc., 1997.
The Bouillon and Karney after-tax valuation model states:
V = Z (N)(1 - R) [[Sigma].sub.1] / [(1 - M)(Z - 1) + Z[[Sigma].sub.2] - (A - B - AB)(1 - RC) - MP + R(1 - L) [K + [Lambda](C - 1)1]
V = Original value of the property.
Z = [(1 + y).sup.m].
y = Yield rate.
m = Holding period.
N = Net operating income before the deduction for interest and depreciation in period 1.
R = Marginal tax rate.
[[Sigma].sub.1] = [summation of] [[(1 + g).sup.t-1] / [(1 + y).sup.t]] where t = 1 to m
g = Constant growth rate per period for the net operating income before the deduction for interest and depreciation (N).
M = Original mortgage-to-value ratio.
[[Sigma].sub.2] = [summation of] [Mf(1 - [a.sub.t]R) - [k.sub.t]R (1 - L) / [(1 + y).sup.t]] where t = 1 to m
f = i[(1 + i).sup.n] / [(1 + i).sup.n] - 1
i = Interest rate per period on the mortgage.
n = Number of equal payments due over the term of the mortgage. i/f; when t = 0
[[Alpha].sub.t] = [i [(1 + i).sup.t-1]/f] - [[summation of] i[(1 + i).sup.d] where d = 0 to t-2] when t = 0
In other words, [Alpha].sub.t], is the proportion of the mortgage payment that is interest in period t. Therefore, (1 - [[Alpha].sub.t]) is the proportion that is principal.
[k.sub.t] = Percentage of the depreciable amount written-off in period t.
L = Proportion of V valued as land.
A = Proportion by which property is expected to appreciate during the holding period. When there is an assumed constant growth rate per period (G), A = [(1 + G).sup.m]-1.
B = Selling expense as a proportion of the selling price.
C = Tax rate on capital gains divided by the marginal tax rate (R).
P = f(m - [summation of] [[Alpha].sub.t] where t = 1 to m)
This is the proportion of the mortgage paid off. Therefore, (1 - P) is the proportion not paid.
K = Sum of kt over the holding period.
[Lambda] = Proportion of the depreciable amount that will not be recaptured as ordinary income. This is the sum of the straight-line rates over m.
Marvin L. Bouillon, PhD, is an associate professor of accounting at Iowa State University in Ames. He has written written articles on income property valuation and other decision models for real estate journals. Contact: (515) 294-9276. Fax 294-3525. email@example.com.
Timothy D. West, PhD, is an assistant professor of accounting at Iowa State University in Ames. He has had numerous articles published in real estate journals. Contact: (515) 294-8106. Fax 294-3525. firstname.lastname@example.org.
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|Title Annotation:||includes appendix|
|Author:||Bouillon, Marvin L.; West, Timothy D.|
|Date:||Jan 1, 1999|
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