Unit 18

Question 1

Learning Objective: Explain the advantages and disadvantages of investing in real estate.

Answer 1

Answer: Advantages include potential for appreciation, regular income from rent, tax benefits, and diversification of investment portfolio. Disadvantages include lack of liquidity, management responsibilities, and risks from market fluctuations and property-specific issues.

Question 2

Learning Objective: Describe major components of the investment decision: property appreciation, income potential, and the use of leverage and pyramiding.

Answer 2

Answer: Property appreciation increases asset value over time, income potential arises from rental revenues, and leverage uses borrowed funds to maximize returns. Pyramiding involves reinvesting equity or profits to acquire additional properties.

Question 3

Learning Objective: Identify the key tax benefits of investing in real estate.

Answer 3

Answer: Tax benefits include deductions for mortgage interest, property depreciation, maintenance expenses, and deferrals or exclusions of capital gains through exchanges or installment sales.

Question 4

Learning Objective: Distinguish the types of real estate investment syndicates and/or trusts.

Answer 4

Answer: Syndicates may include general partnerships, limited partnerships, and real estate investment trusts (REITs). REITs allow investors to pool resources for large-scale property investments, offering income without direct property management responsibilities.

Question 5

Key Term: Adjusted Basis

Answer 5

Definition: The original cost of a property plus improvements, minus depreciation claimed for tax purposes.

Question 6

Key Term: Appreciation

Answer 6

Definition: An increase in property value over time due to market conditions or improvements.

Question 7

Key Term: Basis

Answer 7

Definition: The original cost of a property, used for tax purposes to calculate gains or losses.

Question 8

Key Term: Boot

Answer 8

Definition: Non-like-kind property or cash included in a property exchange to balance values between parties.

Question 9

Key Term: Cash Flow

Answer 9

Definition: The net income from a property after deducting all operating expenses and debt service.

Question 10

Key Term: Capital Gain

Answer 10

Definition: The profit earned from the sale of a property, calculated as the difference between the selling price and the adjusted basis.

Question 11

Key Term: Depreciation

Answer 11

Definition: A tax deduction that accounts for wear, tear, and obsolescence of investment property.

Question 12

Key Term: Diversification

Answer 12

Definition: The strategy of spreading investments across different asset classes to minimize risk.

Question 13

Key Term: Exchange

Answer 13

Definition: A transaction in which one investment property is traded for another, potentially deferring capital gains taxes.

Question 14

Key Term: Inflation

Answer 14

Definition: The decrease in purchasing power of money due to an increase in prices over time.

Question 15

Key Term: Installment Sale

Answer 15

Definition: A sale of property where the buyer makes payments over time, allowing the seller to report gain incrementally for tax purposes.

Question 16

Key Term: Intrinsic Value

Answer 16

Definition: The inherent worth of a property based on its unique features and location, independent of market conditions.

Question 17

Key Term: Leverage

Answer 17

Definition: The use of borrowed funds to finance the purchase of real estate, amplifying potential returns on investment.

Question 18

Key Term: Pyramiding

Answer 18

Definition: A strategy where equity or profits from one property are reinvested to acquire additional properties.

Question 19

Key Term: Real Estate Investment Trust (REIT)

Answer 19

Definition: A company that owns, operates, or finances real estate, allowing investors to earn income from real estate without direct ownership.

Question 20

Key Term: Real Estate Mortgage Investment Conduit (REMIC)

Answer 20

Definition: A special-purpose vehicle used to pool mortgage loans and issue mortgage-backed securities.

Question 21

Key Term: Tax Credit

Answer 21

Definition: A direct reduction in tax liability, often provided as an incentive for investments in specific types of real estate, such as historic preservation or low-income housing.

Question 22

Key Term: Tax Shelter

Answer 22

Definition: Legal strategies used to reduce taxable income, such as property depreciation, mortgage interest deductions, and capital gains deferrals.

Question 23

When an investor purchases a parcel of real estate through the use of borrowed funds, she is taking advantage of
A. leverage.
B. depreciation.
C. capital gains.
D. exchanging.

Answer 23

Answer: A. Leverage.
Reasoning: Leverage allows an investor to use borrowed funds to increase purchasing power and amplify potential returns.

Question 24

An investment syndicate in which all members share equally in the managerial decisions, profits, and losses involved in the venture is an example of a
A. real estate investment trust.
B. limited partnership.
C. real estate mortgage trust.
D. general partnership.

Answer 24

Answer: D. General partnership.
Reasoning: In a general partnership, all members share management responsibilities and profits/losses equally.

Question 25

The increase of money in circulation coupled with a rise in prices, resulting in a decline in the value of money, is called
A. appreciation.
B. inflation.
C. deflation.
D. recapture.

Answer 25

Answer: B. Inflation.
Reasoning: Inflation occurs when increased money supply and rising prices reduce the purchasing power of money.

Question 26

For both income and appreciation purposes, Mary is contemplating the purchase of an apartment building as an investment at a price of $150,000. All else being equal, which choice should yield Mary the largest percentage of return on her initial investment after the first year?
A. Mary pays $150,000 cash for the property.
B. Mary gives the seller a $75,000 down payment and a 15-year purchase money mortgage for the balance at 11% interest.
C. Mary gives the seller $15,000 down and obtains a 30-year mortgage for the balance at 12% interest.
D. Mary gives the seller $20,000 down and agrees to pay the seller 10% of the unpaid balance each year for 10 years, plus 11% interest.

Answer 26

Answer: C. Mary gives the seller $15,000 down and obtains a 30-year mortgage for the balance at 12% interest.
Reasoning: Using a smaller down payment maximizes leverage, increasing the return on Mary’s initial investment.

Question 27

For tax purposes, the initial cost of an investment property, plus the cost of any subsequent improvements to the property, less the amount of any depreciation claimed as a tax deduction, represents the investment’s
A. adjusted basis.
B. gains.
C. basis.
D. salvage value.

Answer 27

Answer: A. Adjusted basis.
Reasoning: The adjusted basis accounts for the original cost, improvements, and deductions for depreciation, used to calculate gains or losses on sale.

Question 28

Julia is exchanging her apartment building for an apartment building of greater market value and must include a $10,000 boot to even out the exchange. Which of the following may she use as a boot?
A. $10,000 cash
B. Common stock with a current market value of $10,000
C. An automobile with a current market value of $10,000
D. Any of the above if acceptable to the exchangers

Answer 28

Answer: D. Any of the above if acceptable to the exchangers.
Reasoning: Boot can be any asset, including cash, stock, or personal property, as long as both parties agree to its use in the exchange.

Question 29

A property’s equity represents its current value less
A. depreciation deductions.
B. mortgage indebtedness.
C. physical improvements.
D. selling costs and depreciation deductions.

Answer 29

Answer: B. Mortgage indebtedness.
Reasoning: Equity is the difference between the property’s current market value and the amount owed on any mortgages.

Question 30

Barney sold his four-unit apartment building and purchased a six-unit building of the same market value. The gain on the sale of his four-unit apartment building is $28,000. This gain
A. will not be taxed, because Barney exchanged properties.
B. will be taxed.
C. will be amortized over 27½ years.
D. is called net debt relief.

Answer 30

Answer: B. Will be taxed.
Reasoning: While exchanges can defer gains, Barney’s transaction does not meet the conditions of a tax-deferred exchange under Section 1031.

Question 31

In an installment sale, taxable gain is received and must be reported as income by the seller
A. in the year the sale is initiated.
B. in the year the final installment payment is made.
C. in each year that installment payments are received.
D. at any one time during the period installment payments are received.

Answer 31

Answer: C. In each year that installment payments are received.
Reasoning: Installment sales allow sellers to spread taxable income over the years when payments are received.

Question 32

When investors hold and refinance investment properties, using their equities as leverage, they are taking advantage of which concept?
A. Pyramiding
B. Tax-sheltered income
C. Recapture
D. Useful life

Answer 32

Answer: A. Pyramiding.
Reasoning: Pyramiding involves reinvesting equity or refinancing proceeds to acquire additional properties and grow the investment portfolio.

Question 33

A small multifamily property generates $50,000 in rental income with expenses of $45,000 annually, including $35,000 in debt service. The property appreciates about $25,000 a year. On this property the cash flow is
A. $5,000.
B. $15,000.
C. $25,000.
D. $30,000.

Answer 33

Answer: A. $5,000.
Reasoning: Cash flow is calculated as rental income ($50,000) minus total expenses ($45,000), excluding appreciation.

Question 34

Shareholders in a real estate investment trust generally
A. receive most of the trust’s income each year.
B. take an active part in management.
C. do not pay IRS taxes on their income from the REIT since the REIT pays taxes as a corporation.
D. realize their main profit through sales of property.

Answer 34

Answer: A. Receive most of the trust’s income each year.
Reasoning: REITs are required to distribute at least 90% of their taxable income to shareholders annually.