Problem 11-3 You are an employee of University Consultants, Ltd., and have been given the following assignment. You are to present an investment analysis of a small retail income-producing property for sale to a potential investor. The asking price for the property is $1,263,000 rents are estimated at $161,300 during the first year and are expected to grow at 2.5 percent per year thereafter. The investor tells you she would like to know how tax considerations affect your investment analysis. You determine that the building represents 85 percent of value and would be depreciated over 39 years (use 1/39 per year, except year 1 depreciation is also multiplied by 11.5 / 12 to adjust for the mid month convention). The potential investor indicates that she is in the 37 percent tax bracket and has enough passive income from other activities so that any passive losses from this activity would not be subject to any passive activity loss limitations. Capital gains from price appreciation will be taxed at 20 percent and depreciation recapture will be taxed at 25 percent. Because the investor works over 750 hours per year in real estate related activities, she is able to avoid the NIIT 3.8 percent surcharge.

Required:

a. What is the investors expected after-tax internal rate of return on equity invested (ATIRR)?

b. What is the effective tax rate and before-tax equivalent yield?

d. Recalculate the ATIRR in part (a) under the assumption that the investor cannot deduct any of the passive losses (they all become suspended) until the property is sold after five years.