You are an employee of University Investment Consultants, Ltd. and have been given the following assignment. You are to present an investment analysis of a new small residential income producing property for sale to a potential investor. The asking price for the property is $1,200,000; rents are estimated at $200,000 during the first year and are expected to grow at 2.5 percent per year thereafter. Vacancies and collection losses are expected to be 10 percent of rents. Operating expenses will be 35 percent of effective gross income. A 70 percent loan can be obtained at 10 percent interest for 30 years. The property is expected to appreciate in value at 2.5 percent per year and is expected to be owned for five years and then sold. Fees and expenses involved in resale of the property is expected to be 2% of the selling price.

The investor tells you that she would also like to know how tax considerations affect your investment analysis. You determined that the building represents 90 percent of value and would be depreciated over 39 years (use 1/39 per year). The potential investor indicates that she is in the 36 percent tax bracket and has enough passive income from other activities so that any passive loans form 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.

a. What is the investor’s expected after tax IRR (ATIRR) on equity? How does this compare with the before tax IRR (BTIRR) calculated earlier?

b. What is the effective tax rate?