A residence and associated land are for sale for $155K. $45K is estimated to be

Question

A residence and associated land are for sale for $155K. $45K is estimated to be the land’s value and $110K is the residence’s value. If bought, the residence can be rented to provide a net rental income of $12K per year net benefit after all expenses are taken into account except depreciation. Depreciation would be on an S/L basis utilizing a 27.5 year life and no salvage value. The purchaser wants a 10% after-tax ROR after consideration of both the annual income taxes and the potential capital gain on the sale of the property. At what sales price would the purchaser need to sell the property after 10 years of ownership to realize this return? The purchaser’s incremental income tax rate is 28% in each of the 10 years.

Explanation / Answer

Cost of Land & Residence combined = $ 155K Cost of Land = $ 45K Cost of Residence = $ 110K We are given that the purchaser needs to acquire a 10% after tax Rate of Return on this investment. Thus, Return required = Cost of Land and Residence * Rate = $155K * 10% = $15.5K This implies that the purchaser wants to get back a total of $ 170.5K from this property in 10 years. Now, we are given that the Net Rental Income per year is $ 12K Depreciation is chargeable on the residence and not on the land Depreciation per year = Cost of Residence/Years Depreciation per year = $110K/27.5 Depreciation per year = $4K Net income from residence after depreciation per year = $12K - $4K = $8 K Tax Rate is given as 28% Thus, tax per year = $8K * 28% Tax per year = $2.24K Net Income per year after depreciation & tax = $8K-$2.24K = $5.76K Net Income from Residence and Land in 10 years = $5.76*10 = $57.6K Required Return from Residence and Land in 10 years = $ 170.5K Selling Price to realise the value = $170.5K - $57.6K = $112.9K

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