INCOME TAX AND INVESTMENTS

Income tax is generally ignored in valuation practice because: Some tax advantages such as negative gearing are ignored as it is too particular or personal to certain investors and ephemeral in the long term. Real estate investment is a long term investment. However, there may be tax advantages with some buildings compared to other buildings and opportunity cost investments for example, tourist accommodation. New buildings enjoy tax benefits which pass to a new owner on sale and therefore, such buildings have an investment advantage over other otherwise comparable buildings.

STRUCTURAL IMPROVEMENTS

New income producing properties allow tax deductions for capital expenditure on the construction of the building, if used for the purpose of producing assessable income. Capital expenditure on building extensions can qualify on a similar basis. Although there is some flexibility in the depreciation allowance typically, a straight line rate of 2.5% per annum of capital cost is used. That is, the cost is written off over 40 years. Capital costs include preliminary expenses such as architects' and engineers' fees and the cost of foundation excavations. However, capital expenditure on land such as clearing does not qualify. Under the structural improvements component any expenditure incurred on plant or articles that qualify as depreciable property (eg lifts and air conditioning plant) is disregarded. However, such property continues to be depreciable under the general depreciation provision.

ITEMS OF PLANT

The Taxation Office has a list of allowable items of plant and takes the view that to constitute a unit, the item must be functionally complete. Typically, a 20% rate is applied over 5 years.

TAX BENEFIT

Tax benefit cash flows can be used to determine the return on investment after tax. The DCF can be used by the valuer to determine the present value of tax benefits which may be different from that applicable to the comparable sale properties and therefore be able to adjust comparable sales for income tax differentials.

CONSTRUCTING A TAX BENEFIT DCF EXAMPLE

Assume the building has just been completed.
The new owner would qualify for the following tax benefits:
Plant qualifying for depreciation @ 20% per annum: 500 000 = 100 000pa
Structural cost qualifying @ 2.5% per annum: 1 000 000 = 25 000 pa
Company tax rate: 36%

Therefore annual tax benefit for plant:     36 000
Annual tax benefit for structure:                   9 000
                                                                             ----------
Total:                                                                   45 000

Discount rate: 10% pa

The structural cost benefits will also be due 20 years after the 5 year period and therefore, a present value of the annual benefit will need to be determined at year 5. This can be done with the PV.PMT formula:

PV.PMT(1) = (1-1/1+in)/i

Where: PV.PMT(1) = present value of 1 per annum factor i = interest rate as a decimal n = period

For the subject property:

PV.PMT(9000) = (1-1/1.1020)/.10 * 9000 = 76 622

TABLE

 ITEM
YEARS$ '000

0
1
2
3
4
5
PURCHASE PRICE:
(2000)




RENTAL INCOME: Lease1:
100 100  108.17 108.16 116.99
Lease 2:

66 66 
71.39 74.24 77.21
Annual tax benefits:

45
45
45
45
45
Reversionary tax benefit:





76.62
END MARKET VALUE:





2340
TOTALS:
(2000)
211
211
224.55
227.40
2655.82
DISCOUNT FACTORS: @14.18%pa (rounded) 1.000
0.876
0.767
0.672
0.588
0.515
DISCOUNTED CASH FLOWS (rounded): (2000)
184.80
161.81
150.86
133.81
1368.68
NET PRESENT VALUE (NPV):
00.00





Therefore, the equated yield after tax is 14.18% per annum showing a substantial increase (2.67%) in the rate of return over an otherwise comparable investment property.