REAL ESTATE INVESTMENTS AND BUSINESS OPPORTUNITY BROKERAGE
OVERVIEW In this , the following topics are discussed: various types of investment real estate, types of risk associated with the purchase and ownership of real estate, methods of analyzing such investments, the tax consequences of both owner-occupied and investment real estate, and the distinction between most real estate transactions and the sale of a business.
OBJECTIVES After completing this , you should be able to do all of the following:
Distinguish among the different types of real estate investments
Identify the advantages and disadvantages of investing in real estate
Calculate the percent of profit or loss, given the original cost of the investment, the sale price, and the dollar amount of profit or loss
Distinguish among the various types of risk
Explain the importance of investment analysis
Describe the similarities and differences between real estate brokerage and business brokerage
Describe the types of expertise required in business brokerage
Distinguish among the methods of appraising businesses
Explain how to determine taxable income of investment real estate
Distinguish between installment sales and like-kind exchange
Describe the steps in the sale of a business
KEY TERMS Appreciation Asset
Basis
Capital gain/loss Cash flow
Debt service Equity
Going concern value Goodwill
Installment sale Leverage
Like-kind exchange Liquidation value approach Liquidity
Profit Risk
Tax shelter Taxable income
REAL ESTATE INVESTMENT ANALYSIS
The purchase of real estate as an investment has been popular for both high- and
moderate-income investors. Most investment decisions depend on the rate of return or
profit, which the investor expects to earn by assuming a risk in real estate or other type
of investment. A real estate sales associate can be a major resource to a potential
investor if he or she is familiar with investment real estate, which includes both
terminology and analysis.
A thorough analysis is critical when evaluating the potential of a real estate
investment. Investment analysis must take into consideration land use controls, such as
zoning, deed restrictions, and permitting requirements that affect the value of a property.
Investment analysis considers economic forces, such as population growth,
investment of foreign capital, and the impact of taxation on real estate investments. The
most important factor underlying every investment decision is economic soundness.
Real estate licensees should be capable of evaluating the advantages and
disadvantages of a potential real estate investment compared to alternative investments.
The process of investment analysis begins with the search for and location of
potentially desirable real estate investments that are based upon the investor’s personal
objectives.
Real estate investors can receive potentially significant rewards from real estate
investments that include income generated by the property, a build-up of equity,
appreciation in value, tax benefits, positive leverage, and prestige. Investment in real
estate can also serve as a hedge against inflation when the property has level-payment
mortgage where the payments remain the same, but the rental income increases with
inflation.
Disadvantages of investing in real estate include the illiquidity of property (it cannot
be bought or sold as quickly as other assets), the local (immobile) nature of the real
estate market compared to other types of investments that can be bought and sold in a
variety of markets, the expense or overhead required to manage the property or hire a
property manager, and the need for additional investment assistance from experts such
as brokers, tax accountants, and other professionals.
TYPES OF INVESTMENT PROPERTIES
The following discussion provides information about some of the different types of
real estate available for investment.
Agricultural. Agricultural property investors have many different motivations for
investing in agricultural land. Some investors wish to personally engage in
agricultural endeavors, while others may own the land and lease it to others for
agricultural activities. Investors may also purchase agricultural land in the path of
growth, allowing for lower taxes through agricultural exemptions, before
ultimately selling or developing the property.
Business opportunities. Business opportunities are typically smaller local
businesses, such as barbershops, hair salons, print shops, corner stores, and
boat rental businesses. Often an investor may be looking for a small business
that he or she could own and manage, creating an income for him or herself.
Business opportunities are normally valued based upon applying a multiplier to
the net income being produced by the business. Value may also be applied to
intangible assets such as a business’s name or reputation in the community.
Commercial. Commercial investment properties include retail centers, such as
regional shopping centers usually located near major transportation routes. Major
retail centers attract anchor tenants that draw people to the center. Typically,
these are the name-brand department stores in which people plan to shop. They
are called generative functions, since they generate customer traffic to the
center. Suscipient functions are businesses that attract passersby, such as card
and gift shops, ice cream and novelty stores, and so on.
Real Estate Investments and Business Opportunity Brokerage
Industrial. Industrial investment properties involve manufacturing, assembly, and
distribution. These properties are located most often near major transportation
arteries. Weight-reducing operations, such as mining operations, prefer locations
near the source of their raw materials. Weight-gaining operations, such as
assembly plants, prefer locations close to their market areas in order to reduce
transportation costs.
Office. Office investment properties are usually located in central business
districts or professional office parks in suburban areas near their tenant base.
Offices are usually good long-term investments since office tenants generally
lease for extended periods.
Residential. Residential investment property is available in a wide range of
prices. Important factors to be considered when selecting residential properties
are location, availability of transportation, schools, and shopping. Typical
residential investments include condominiums, villas, single-family homes, and
apartment complexes.
Real Estate Investment Trust (REIT)
A real estate investment trust (REIT), a type of business trust, allows groups of
investors to invest in income-producing property. A REIT provides a method for
individuals to pool financial resources to invest in larger, professionally managed
properties. Investment trusts invest in office buildings, large apartment complexes, and
retail centers. Purchasing shares in a REIT is similar to purchasing shares in a mutual
fund. (Please refer to , Joint Business Relationship section for more
information on a business trust relationship.)
REAL ESTATE INVESTMENT TERMINOLOGY
Amount Realized
The amount realized, also referred to as net proceeds from sale, is expressed by the
following formula:
Amount Realized = Sale Price – Costs of Sale
Sale price is the total amount the seller receives for the sale, including money, notes,
mortgages, or other debts the buyer assumes as part of the sale. The costs of sale
include brokerage commissions, relevant advertising, legal fees, seller-paid points, and
other closing costs paid by the seller.
Basis
Basis, or cost basis, is the original value of an asset for tax purposes. When
purchasing a home, the basis includes the purchase price and any associated
acquisition costs. Basis is used to determine the gain or loss on the sale, exchange, or
other disposition of a property.
Adjusted basis is a measurement of how much is invested in a property for tax
purposes, including any IRS-allowed improvements, referred to as capital improvements.
Examples of capital improvements include a new addition to the home, paving the
driveway, replacing the roof, installing central air conditioning, and rewiring the home. By
adding the cost of improvements to the basis, the amount of gain is reduced, thereby
decreasing the amount of capital gains tax otherwise owed. Refer to “Tax Benefits of
Homeownership” in for tax benefits associated with the sale of a principal
residence.
The adjusted basis may also include certain IRS-allowed reductions including such
items as depreciation of investment property, casualty losses, and residential energy
credits.
The basic formula for adjusted basis is:
Adjusted Basis = Cost Basis + Increases – Decreases
Capital Gain/Loss
A capital gain is an increase in the value of an asset, such as personal or investment
property, that gives it a higher value than the cost of purchasing the asset. If a property
sells for more than the purchase costs, there is a capital gain. A capital loss is incurred
when there is a decrease in the value of an asset that gives it a lower value than the cost
of purchasing the asset.
A capital gain or loss is not realized until the property is sold. A capital gain may be
short term (one year or less) or long term (more than one year) and must be claimed on
the investor’s tax return.
The capital gain is represented by the basic formula:
Gain = Amount Realized – Adjusted Basis
Cash Flow
Cash flow is the movement of money into or out of a business or investment,
measured over a period-of-time. Generally speaking, cash flow is the money that
remains after all the income, such as rents, is collected and all the day-to-day expenses
associated with owning the property are paid.
Cash flow can be ongoing or one-time. Ongoing cash flows are received by the
investor throughout the investment-holding period, as in rental income. One-time cash
flows are sales proceeds received as a result of the sale of an investment property.
Cash flows may be positive or negative. Positive cash flow occurs when there is
more money coming in than going out, resulting in money remaining. Negative cash flow
occurs when there is more money going out than coming in, resulting in a deficiency that
the investor or business owner must pay out of pocket. Most investors and business
owners desire a positive cash flow in order to achieve a profit and a high rate of return
on their investment. However, there are tax benefits to negative cash flows.
Appreciation
Appreciation is an increase in the value of an investment over time. Investment
property can appreciate in value for many reasons, such as inflation, supply and
demand, and capital improvements. Most real estate investors purchase income
property with the goal of realizing a positive cash flow and appreciation.
Tax Depreciation
Tax Depreciation, also referred to as cost recovery, is an income tax deduction that
allows a taxpayer to recover the cost of investment property over a number of years.
Real Estate Investments and Business Opportunity Brokerage
Equity
Equity is the difference between the current market value of a property and the
amount the owner still owes on the mortgage. The initial down payment creates equity.
Additional equity is created through principal reduction and appreciation.
One advantage of investing in real estate is the equity build-up that can occur on
mortgaged rental property. An investor who collects rent from a tenant can use the rental
income to pay expenses and reduce the principal amount of the loan, which can
increase the equity in the property. Over time, the tenant essentially pays for the
property to the benefit of the investor. Some investors consider equity build-up as a good
use of cash flows when the interest rates on savings accounts and certificates of
deposits are lower than the rate of return on the investment property.
Liquidity
Liquidity refers to an asset’s ability to be easily converted through an act of buying or
selling without causing a significant movement in the price and with minimum loss of
value. Cash is the most liquid asset. A liquid asset can be sold rapidly with minimal loss
of value. The essential characteristic of a liquid market is that there are ready and willing
buyers and sellers at all times.
An illiquid asset is one which is not readily saleable due to uncertainty about its value
or a lull in the market in which it is regularly traded. One disadvantage of investing in real
property is that property is considered an illiquid asset, which cannot be transferred as
easily as other assets, such as stocks or bonds.
Tax Shelter
A tax shelter is a legal method of minimizing or decreasing an investor’s taxable
income, and therefore, his or her tax liability. Depreciation of a real estate investment
can reduce an investor’s taxable income and is, therefore, a form of tax shelter.
Risk
Risk is the possibility of losing all or part of the investment. Every investment
involves a certain degree of risk. There are two primary types of risk: dynamic and static.
Dynamic risk. Dynamic risk is risk associated with changes in general market
conditions. The different types of dynamic risk are outlined below.
o Business risk. Business risk is the possibility that an investment will yield
lower than anticipated profits, or that it will experience loss rather than a
profit. Business risk is measured by comparing actual income and expenses
to budgeted income and expenses. If expenses are higher than projected,
and/or income is lower than projected, the investment could be in jeopardy.
o Financial risk. Financial risk is associated with extremely high expenses
and/or extremely low income. The investor may be faced with adding to the
original investment to keep it in operation. In the alternative, the investor may
have to borrow more money or sell other assets to raise capital to prevent
losing the investment. If an investor is unable to make the required payments
on their debt obligations, they risk defaulting on the loan.
o Inflationary risk. Inflationary risk, or purchasing-power risk, is the risk that future inflation will cause a decrease in purchasing power of the currency, resulting in a rise in the cost of goods and services. Inflation causes the investor’s expenses to increase. Potential buyers may also lack the purchasing power to buy the property.
o Interest rate risk. Interest rate risk is the effect of the economy on the investment. If the value of a dollar increases or decreases because of inflation or deflation, interest rates could increase or decrease, which may affect the value of the investment or reduce the likelihood of selling it.
o Liquidity risk. Liquidity risk is the risk that an investment property cannot be bought or sold quickly enough to prevent or minimize loss.
o Market risk. Market risk is the possibility for an investor to experience losses due the effect of the national or local real estate market. There are many sources of market risk that can affect the real estate market, including recessions, unemployment rates, availability of financing, changes in the economy, and other local conditions affecting specific markets.
Static risk. Static risk is risk that can be offset with insurance, such as fire, flood, robbery, and so on.
Investors attempt to evaluate and minimize risk. A feasibility study is used as a basis
for making a real estate investment decision. The feasibility study assesses financial,
governmental, legal, social, physical, and locational factors that may influence the
investor’s decisions, based on anticipated risk and potential reward.
Leverage
Leverage is the use of borrowed funds to purchase assets. Most investors make real
estate investments with borrowed money. Positive leverage allows an investor to earn a
higher rate of return on funds invested by borrowing than they could earn by paying cash
for the investment. Financial leverage can be either positive or negative.
Positive leverage. Positive leverage occurs if the investment returns more to the
investor than the cost of borrowing the money necessary to purchase the
investment.
Negative leverage. Negative leverage occurs if the investment returns less to
the investor than the cost of borrowing the money necessary to purchase the
investment.
In most instances, an investor will use leverage to purchase real estate because of
the expectation of positive leverage. However, highly leveraged investments require
cash flows from the property to make the mortgage payments; debt service that is too
high may make that impossible.
EVALUATING INVESTMENT PROPERTIES
Evaluating an investment property begins with the preparation of a reconstructed
operating statement that shows annual forecasts of income and expenses over a period-
of-time. Required rates of return based on forecasted income, expenses, risk, and length
Real Estate Investments and Business Opportunity Brokerage
of the ownership period are applied to estimate the value of the property. The rate used
to estimate value is dictated by the individual investor’s requirements, but tempered by a
competitive market.
An analysis of the past income and expenses of an income-producing property can
help to evaluate the future income of the property. However, it should be noted that new
ownership and new management often result in a change in the operating characteristics
of a property. Historical information is obtained from current owners to serve as a basis
for making projections, but cannot always be relied upon. Consequently, figures
obtained from the current owner must be evaluated based on the individual investor’s
requirements and allowances made for any changes that are anticipated in income and
expenses.
As a result, the analysis must be based on revised historical operating data. In this
case, the reconstructed operating statement includes items that are not included by the
current owner and deletes items that are not expected to recur. Other figures may be
increased or decreased based on the investor’s operating philosophy and management.
The forecast of income and expenses (shown below) is performed in the same
manner as was discussed in the Appraisal of this book. However, investment
analysis goes beyond the calculation of the net operating income and considers the
effect of financing and taxation on the investment.
PGI = Potential gross income (contract rent plus market rent)
– V&C = Vacancy and collection losses
+ OI = Other income (from sources other than rent)
EGI = Effective gross income
– OE = Operating expenses
= NOI = Net operating income
– ADS = Annual debt service (one year’s mortgage payments)
= CTO = Cash throw-off (BTCF, before-tax cash flow)
Operating expenses include fixed expenses, variable expenses, and a reserve for
replacements. Each is outlined below.
Fixed expenses. Fixed expenses include costs that do not change with the level
of occupancy, such as real estate taxes and hazard insurance.
Variable expenses. Variable expenses change with the level of occupancy and
include costs, such as management fees, maintenance, utilities, yard care,
janitorial, and so on.
Reserve for replacements. Reserve for replacements is a noncash expense.
This money is for future use to replace worn-out components, called short-lived
items, such as carpeting, appliances, central heat and air systems, roof
coverings, and so on.
Mortgage payments, called debt service, are not considered an operating expense.
Real estate does not borrow money, people do. The type and amount of financing is
dictated by the needs of the investor, not the property. It would be inappropriate to
charge the property for something unrelated to its operation.
After the net operating income is estimated, debt service is subtracted to obtain the
cash throw-off (CTO). This is also called the before-tax cash flow (BTCF). Investors will
be concerned with an additional computation to determine the after-tax cash flow
(ATCF), which is beyond the scope of the pre-license course.
The objective of real estate investment analysis is to assist an investor in choosing
the best property available among available alternatives and to base a price decision on
the analysis performed. Applying ratios to the forecasted income and expenses can
facilitate analysis. Ratios commonly used in the evaluation of income properties include
the operating expense ratio and the loan-to-value ratio.
Operating Expense Ratio
The operating expense ratio expresses the relationship between the expenses
incurred in operating the property (the operating expenses) with the amount the investor
actually receives (the effective gross income). This relationship is expressed as a
percentage, or ratio. The formula is as follows:
Loan-to-Value Ratio
The loan-to-value (LTV) ratio measures financial risk in an investment by comparing
the mortgage loan amount to the price, or value, of the property. This ratio indicates the
percentage of the property value that is represented by debt. A higher LTV ratio
increases the risk of the borrower’s default. The formula is as follows:
Calculating Profit on Investment
Profits from investments are calculated on the amount that is originally invested, not
on the amount received when the investment is sold or liquidated. The following formula
is used to determine the profit based on the original investment amount paid:
Example: Assume that an investor paid $, for a parcel of land, divided it into
three separate lots, and sold each lot for $,. What is the profit on this
investment?
Solution: The profit on this investment is %. Profits from investments are
calculated on the amount that is originally invested, not on the amount received
when the investment is sold or liquidated.
$ , Sale price of each separate lot
x Number of lots sold
$, Gross sales price
– $, Amount paid
$ , Amount made
To determine the percentage of profit, divide the amount made by the amount paid.
Real Estate Investments and Business Opportunity Brokerage
Rate of Return (ROR)
The money made in an investment is referred to as the return. The investment
amount made with the original purchase is referred to as the capital, or capital
investment. The return from an investment is calculated based upon the capital
investment. Investors want to achieve a high rate of return.
The IRV formula discussed in to derive capitalization rates can also be
used to calculate the rate of return (ROR). When evaluating investments, the ROR
replaces the cap rate that was used in . Dividing the net operating income
(NOI) by the investment value will provide the investor with the ROR.
If the investor wishes to determine the rate that is being received based upon the
actual equity invested (vs. the rate on the overall investment), then an equity dividend
ratio would be used. The formula for equity dividend ratio (EDR) is:
The equity dividend ratio provides the investor with a more accurate picture as to the
return on the money actually invested.
Loan Constant
A loan constant is an interest and principal factor used to calculate a level monthly
payment necessary to pay off both principal and interest over the term of the loan.
Today, financial calculators and computers are typically used to calculate payments and
amortization schedules. In the past, booklets were published where the interest rate and
term of the loan were matched to arrive at a constant. The constant was then applied to
the original loan amount to determine the monthly payment.
Example: Calculate the monthly payment on a new loan of $, at % for
years, using a monthly loan constant of ..
Solution:
Loan Balance x Loan Constant = Monthly Payment
$, Loan balance
x . Loan constant
$. Monthly payment
IMPACT OF FEDERAL TAXATION
Real estate investment strategies and long-term planning of investment portfolios are
impacted by federal taxation. Since taxation is an important consideration in all real
estate transactions, real estate licensees must be knowledgeable concerning tax
matters. However, they must also exercise extreme caution to avoid giving advice
regarding tax matters. Investors should be advised to seek the advice of qualified
experts in the field of taxation.
The Tax Reform Act of , the Tax Act of , the Taxpayer Relief Act of ,
and revisions to the tax code made in have made significant changes in tax
treatment associated with real estate. The following discussion presents some of the
changes related to these laws.
Depreciation
One benefit that is not available to homeowners but is available to investors and the
owners of businesses is the ability to deduct a portion of the money that they have
invested in their property each year from their gross income. This deduction is referred
to as cost recovery, or tax depreciation.
A system called the Modified Accelerated Cost Recovery System (MACRS) was
adopted in , thereby replacing the Accelerated Cost Recovery System that was
implemented in . Cost recovery, in the language of the tax code, refers to tax
depreciation. The MACRS stipulates the time periods over which investment real estate
can be depreciated for tax purposes. The time period begins when the property is placed
in service, which, essentially, means the time in which title is taken.
Tax law currently allows the owners of residential and low-income investment
properties to depreciate a portion of their investment over . years on a straight-line
basis. The residential category includes single-family rentals, all apartment rentals, and
mobile homes. The owners of nonresidential investment properties may depreciate a
portion of their investment over years, also on a straight-line basis. Hotels and motels
are classified as nonresidential.
To calculate the amount of the allowable deduction, the total cost of acquisition,
including the total cost of the property plus closing costs, is allocated on a percentage
basis to the land and improvements. The basis for depreciation is that portion of the total
cost, including closing costs, which applies to the improvements. Land cannot be
depreciated. This amount is evenly divided by the number of years allowed, either .
or , depending on the type of property. That is what is meant by straight-line; the same
dollar amount is deducted each year. This percentage can be calculated by having an
appraisal made or using the percentages of land and improvements utilized by the
property appraiser’s office. The basis is reduced each year by the amount allowed until
the total depreciable basis equals zero or the property is sold.
Example: An apartment complex was purchased for $,; closing costs were
$,. An appraisal indicated the improvements represented % of the value of
the property. What amount may the investor deduct each year for tax purposes?
Solution:
$, Purchase price
+ $ , Closing costs
$, Total acquisition cost
x . Improvements percentage
$ , Basis for depreciation
In the example above, the investor can claim $, each year as an expense on
his or her personal tax return until the entire $, has been claimed.
Real Estate Investments and Business Opportunity Brokerage
Capital Gains Tax
Capital gain is profit made when an income property is sold.
Under the American Taxpayer Relief Act of , the top capital gain tax rate has
been permanently increased to % (up from %) for single filers who have incomes
above $, and married couples filing jointly who have incomes exceeding
$,. The Act also changed the depreciation recapture rate to % for all
taxpayers, independent of tax bracket.
A summary of the current capital gain tax rates for taxable income ranges follows:
If tax depreciation has been deducted during the ownership period, the proceeds of a
sale will be taxed at two different rates. The capital gains tax rate shown above is for
capital assets held over months. A portion of depreciation claimed during the
ownership must be recaptured at the time of sale, and is taxed at a depreciation
recapture rate of %. Profit made on the sale of property owned for a period of
months or less is taxed at the investor’s ordinary tax rate.
Example: Capital gains tax calculation.
An apartment building was purchased for $, by an investor with a taxable
income of $,. Closing costs were $,. An appraisal indicated the value of
the improvements represent % of the value of the property.
Only that portion of the purchase price allocated to the improvements can be
depreciated. The basis for depreciation is reduced each year to arrive at the adjusted
basis. When the adjusted basis reaches zero, no further depreciation may be
claimed.
After five years of ownership, the adjusted basis is calculated as shown:
$, Purchase price
+ $, Closing costs
$, Acquisition cost
x . Improvement percentage
$, Basis for depreciation
, Annual depreciation allowance
x Years of ownership
$, Total depreciation
$, Basis for depreciation
– $, Depreciation claimed
$, Adjusted basis
If the property was held longer than months and sold for $,, the capital
gains tax due on sale would be calculated in two steps:
Step $ , Sales price $, Capital gain
– , Acquisition cost x . Capital gains tax rate
$ , Capital gain $ , Tax on gain
Step $, Depreciation recaptured $ , Capital gains tax
x . Tax rate on recapture + , Tax on recapture
$ , Tax on recapture $ , Total tax due
Income Classification
Under the Tax Reform Act of , income must be separated into three categories:
active, passive, and portfolio.
Active income. Active income is income from salaries and wages.
Passive income. Passive income includes income from rental activity and any
investments in which the investor does not materially participate.
Portfolio income. Portfolio income is income from dividends.
The significance of the separation of income into separate categories is that a loss
cannot be offset against income from another classification; it can be offset only by
income in the same classification. This is in order to eliminate many forms of tax
shelters, and to expose more income to federal income tax. Losses that cannot be offset
by gains in any given year must be carried forward to subsequent years; they may not
be deducted against income from other sources such as salary, interest, dividends, or
other active business income. If a property is sold at a gain, any losses from previous
years may be used to offset losses carried forward.
Exceptions are as follows:
Limited exception. A limited exception is when a small investor has an
opportunity to retain a tax shelter advantage. An investor with an adjusted gross
income of $, or less may offset up to $, of passive losses against
active portfolio income as long as,
o Management decisions are made by the taxpayer
o The taxpayer owns at least % of the investment
o The adjusted gross income of the taxpayer is below $,
This benefit is phased out on a percentage basis when the investor’s income
rises above $,, and is eliminated when the investor’s income is above $,.
This exception exists even if a rental agent or property management firm
handles the property. Management decisions include approving new tenants,
deciding on rental terms, approving expenditures, and other similar decisions.
Exception for real estate licensees. The exception for real estate licensees is
found in the Tax Law of that provides additional relief for real estate
licensees who spend a minimum of hours per year in the real estate
business and incur passive loss from rental activities. Real estate licensees who
Real Estate Investments and Business Opportunity Brokerage
own investment real estate should contact their tax accountants for clarification of
this provision.
Capital Gains and Losses
A capital gain or loss occurs when an investment or business property is sold for an
amount greater or lesser than the amount paid. Income from properties held for sale to
customers, such as model homes offered for sale by builders, is considered to be an
active income since these are not considered to be investment properties.
As discussed above, passive losses must be carried forward and offset against
future gains from passive activity. Capital gains, on the other hand, are realized income.
Generally speaking, realized income is subject to income tax in the year in which it is
earned.
There are two methods an investor can use when a property is sold to reduce or
defer the amount of tax due on the transaction: a tax-deferred exchange or an
installment sale.
Tax-deferred exchanges. Tax-deferred exchanges allow any capital gain
realized from the sale of investment property to be transferred into another
property by exchanging properties. An investment real estate that is exchanged
for other investment real estate is called a like-kind exchange. The problem with
this type of transaction is that most properties do not have the same value.
Therefore, in order to conclude the exchange, investors often include cash, or
other forms of unlike property, to equalize the transaction. Unlike property
received in a tax-deferred exchange is called boot and is taxable to the recipient.
To the extent that the equities are equal, the capital gain is deferred, or
postponed, until the property is sold.
Note that this does not eliminate the tax; it is allowed to be recognized in a
later tax year. This can be an advantage in tax planning, particularly when an
investor expects to be in a lower income tax bracket in future years.
Installment sale. Installment sale is a form of seller financing. No down payment
is required to qualify as an installment sale. It qualifies as long as at least one
payment is received in a tax year subsequent to the year of sale. Under
installment sale treatment, only the percentage of gain received in any given year
is taxable. Therefore, the gain can be spread over several years, thereby
reducing the amount of tax due in any tax year.
Investment Interest Limitation
Deduction of investment interest is limited to the amount of net investment income
within the tax year. The investment interest limitation applies to all interest paid for tax
years beginning after December , , regardless of when the debt was incurred.
Investment interest. Investment interest is all interest charged on debt that is
not incurred in connection with the taxpayer’s primary trade or business.
Investment income. Investment income is gross income from interest,
dividends, rents, royalties, and income not derived from a trade or business.
Net investment income. Net investment income is the excess of investment
income over investment expense.
At-Risk Rules
A taxpayer may deduct losses from an activity only to the extent of the amount of
investment capital that is at risk.
Retained provisions of the Tax Reform Act of include credits for a taxpayer who
restores a historical building. The Act also provides credits for qualified low-income
housing projects.
BUSINESS ENTERPRISE AND OPPORTUNITY BROKERAGE
Business Brokerage
A business brokerage offers real estate services that are connected with the sale or
lease of businesses. The sale of a business may or may not include the sale of real
property.
Business brokerage consists primarily of analyzing financial statements. Those
engaged in this aspect of real estate are required to have knowledge concerning
business formations, and be able to read and understand operating statements and
financial balance sheets. An income statement is a history of income and expenses over
a stated period, such as a month or a year. A balance sheet reflects the financial
condition of a business as of a particular time.
The sale of a business may involve the transfer of ownership of shares of stock,
limited partnership interests, or other forms of securities. Persons who deal in securities
are required to have a separate license. Real estate licensees must be certain that
securities laws are not violated when listing or selling a business.
The sale or lease of a business is a real estate transaction. Persons and firms that
offer brokerage services connected with the sale or lease of a business are regulated by
F.S. , and are required to hold a real estate license. Regulation of business
brokerage became effective in . The legislature believed a real estate license
should be required in the brokerage of a business since the transaction almost always
involves either the sale of real estate or negotiation of a lease.
A real estate licensee may also need to hold a securities license if the transaction
includes the transfer of corporate stock or limited partnership interests. Legal counsel is
strongly advised before proceeding with the sale of a business.
Business Enterprise Defined
A business enterprise involves transactions that are in excess of $,. The
brokerage of larger businesses usually involves the transfer of stock shares or other
types of security. The transaction may or may not involve the sale of real estate. If not,
negotiation of a lease may be required.
Markets for business enterprises are typically wider in geographic scope than
markets for individual parcels of real estate.
Business Opportunity Defined
Business opportunities involve smaller businesses with sales prices of $, or
less. These businesses typically have a limited amount of assets. The ownership of such
businesses may also involve securities, but many are sole proprietorships or
partnerships that do not.
The sale of many of these businesses involves only the sale of inventory and
fixtures, and an assignment of a lease.
Real Estate Investments and Business Opportunity Brokerage
Expertise Required of Business Brokers
Generally, business brokers work in conjunction with certified public accountants and
attorneys. Business brokers must have an understanding of corporate finance and
knowledge regarding the classes and characteristics of corporate stock, securities
analysis and valuation, capital management, and budgeting.
A business broker must have knowledge regarding business accounting, including
classes of assets and liabilities, income statement analysis, balance sheet analysis,
cash-flow analysis, asset depreciation methods, and taxation.
Appraisal Using the Liquidation Value Approach
The comparable sales approach, cost-depreciation approach, and income approach
(discussed in ) can all be used to appraise a business. A fourth method, the
liquidation value approach, may also be used. This approach is unique to the valuation
of a business.
Liquidation value is the value that remains after liquidating all the assets of the
business and satisfying all the liabilities. This approach is used to value a failing
business that is not expected to continue to do business. It can also be used to establish
the minimum value of a profitable business.
The appraisal of a profitable business presents a unique challenge. The value of the
business is not just the value of any real estate owned, but rather, a composite of the
values of the real estate, personal property, and intangible assets, such as licenses,
franchises, noncompetition contracts, and so on. When the value of all assets is
combined, it creates what is known as going concern value.
Reasons for a Business Appraisal
Business owners or potential purchasers may request an appraisal in order to
establish a sales or purchase price, obtain a loan, or for insurance purposes. Other
reasons include condemnation, buy-sell agreements, property settlements, estate
settlements, or to be used in connection with employee stock option plans.
Uniform Commercial Code
The Uniform Commercial Code (UCC) is a body of standardized rules that regulate
commercial transactions throughout the nation by focusing on the sale and financing of
personal property. Florida has adopted a version of the UCC as law.
When personal property is sold in a commercial transaction, a Bill of Sale is used to
identify the property conveyed. This document is similar to a deed. If financing is
involved, a standard Security Agreement is used to identify the property that is security
for the debt. The Security Agreement is similar to a mortgage and is usually recorded to
protect the lender’s interest in the property.
An attorney must be retained to prepare documents used in compliance with the
UCC; real estate licensees may not prepare these on behalf of customers or principals.
Accounting Terms
Agents involved in the selling of businesses should be familiar with the following
terms and the accounting formula:
Assets. Assets are items of value that are owned by a business. Assets include accounts and promissory notes receivable, cash, inventory, production machinery, real estate, personal property, patents, trademarks, and goodwill (the value of the name of the business in the marketplace).
Liabilities. Liabilities are debts that are owed by a business. Liabilities include accounts and notes payable, and long and short-term debt. Short-term liabilities are debts that must be recognized within one year or less. Long-term liabilities are debts that will not come due for more than a year, such as mortgage balances.
Owner’s equity. Owner’s equity is the difference between assets and liabilities.
Basic accounting formula. The basic accounting formula is
Assets – Liabilities = Owner equity
Capital. Capital is the total amount that is invested. Capital includes the funds that were used to start the enterprise, money that is invested during operation, and retained capital.
Tangible assets. Tangible assets are assets that have physical existence such as buildings, furniture, office equipment, and so on.
Intangible assets. Intangible assets have no physical existence, but have monetary value. Intangible assets include stock shares, trademarks, copyrights, research and development expenses, noncompetition contracts, franchises, and goodwill.
Steps in the Sale of a Business
The steps taken to list and sell a business are not unlike the steps that are taken to
list and sell any other real estate. The exception, of course, is the knowledge and
experience necessary to properly value and market the business.
Step Acquire the listing. The listing process is virtually the same as listing
other property for sale.
Step List the assets. A detailed list of all tangible and intangible assets is
required.
Step Valuation. Estimate the value of the business by using the appropriate
appraisal methods.
Step Deduct liabilities. The value established in Step must be reduced by
the amount of liabilities, long- and short-term. This includes the value of
any preferred, outstanding stock.
Step Valuation of stock. If a corporation is being sold by transferring shares
of stock, the share value must be determined. Divide the net value of the
business by the number of shares to determine the per-share value.
Real Estate Investments and Business Opportunity Brokerage
Step Legal compliance. Review the transaction carefully before proceeding in
order to be certain that all laws have been complied with. This includes
real estate, securities, mortgage brokerage licensing laws, and UCC
requirements.
Step Close the transaction. Locate a buyer who is interested in the business
and conclude the sale.
