FIN 591 Week 4 Taxation and Law Example

The Tax and Legal Side of Mission Oaks: Depreciation, a Cost Segregation Study, Passive Loss Rules, Recapture and a 1031 Exit, Plus Title, Environmental and Tenant Law in Texas

[Student Name]

University of Phoenix

FIN/591: Real Estate Investment

Week 4 Assignment

[Instructor Name]

[Date]

Mission Oaks Apartments, the family office and all figures are composites written for a model paper; tax and legal rules are summarized generally from the sources listed, change over time and should be confirmed with advisers.

The composite Texas family office expects to buy Mission Oaks, the composite San Antonio apartment community, for about $16.25 million through a limited liability company jointly owned with its operating partner, as planned in Week 3. The investment committee had focused on net operating income and the loan. Its tax adviser asked them to look at what the heirs would actually keep. Two investors with identical properties can earn very different returns once taxes are counted, and the difference is often decided before the purchase closes. This paper traces the tax and legal side of ownership.

The Ownership Entity

The limited liability company will be taxed as a partnership, so income, deductions and losses pass through to the members, the family office's trusts and the operator, without a separate entity-level tax. The company also shields members from liabilities arising at the property, and the agency loan from Week 3 requires a single-purpose borrowing entity. Texas imposes no personal income tax, but it does levy a franchise tax on many entities, which small real estate partnerships often pay at modest amounts or are exempt from depending on revenue.

Land and Building

Only the building and improvements can be depreciated. The county appraisal district values the land at about 20 percent of the total, consistent with comparable sites. Of the $16.25 million price plus about $240,000 of capitalized closing costs, about $3.3 million is allocated to land and about $13.2 million to depreciable property.

Straight-Line Depreciation

Residential rental buildings are depreciated over 27.5 years on a straight-line basis. Without further analysis, annual depreciation would be about $480,000, sheltering most of the property's taxable income in early years (Brueggeman & Fisher, 2018).

Cost Segregation and Bonus Depreciation

A cost segregation study, prepared by engineers (Geltner et al., 2014), separates components with shorter lives: carpets, cabinets, appliances and some electrical work as five- or seven-year property, and parking lots, landscaping and fencing as fifteen-year land improvements. For an older garden complex, such studies commonly reclassify about a fifth of the building basis. Here about $2.9 million is reclassified. Under federal legislation enacted in July 2025, property of these classes acquired after January 19, 2025, qualifies for 100 percent bonus depreciation, deductible in the first year. First-year depreciation would be about $2.9 million from the reclassified property plus about $360,000 on the remaining building, about $3.26 million in total.

The First-Year Tax Loss

In year one, net operating income of about $895,000 minus interest of about $600,000 leaves about $295,000 before depreciation. After $3.26 million of depreciation and the study's cost of about $12,000, the partnership reports a tax loss of nearly $3 million, even though it distributes cash.

Who Can Use the Loss

The passive activity rules generally treat rental real estate as passive, so losses can offset only passive income, which generally means income from other rentals or from businesses the owner does not actively run. Unused losses carry forward and are released when the activity is sold. The family's trusts hold other passive investments producing some income, so part of the loss can be used early; the rest will carry forward. The adviser cautioned that individual heirs who are active in real estate businesses may have different results.

Recapture and Gain at Sale

Depreciation reduces the property's tax basis, so it increases the gain when the property is sold. On a sale at about $21.2 million in year ten, the adjusted basis would be roughly $10 million after about $6.6 million of depreciation over ten years, $2.9 million of it on the reclassified components deducted in year one. The reclassified personal property generally produces ordinary income on recapture, up to the value assigned to it at sale, building depreciation is treated as unrecaptured section 1250 gain with a federal rate capped at 25 percent, and the remaining appreciation as long-term capital gain. Much of the early deduction is therefore a deferral of tax, valuable because of its timing, not a permanent saving.

The Value of Deferral

Deferring tax is worth something even if the tax is eventually paid. If the partnership's early deductions shelter about $3 million of income that would otherwise be taxed at around 37 percent, and the same amount is taxed at a blended 25 to 30 percent at sale ten years later, the family gains both from the lower rate and from keeping the money for a decade. At a 7 percent opportunity cost, a dollar of tax deferred for ten years is worth only about 51 cents in today's money. That timing benefit is why investors value accelerated depreciation even though recapture follows.

A Like-Kind Exchange

Section 1031 allows investors to defer gain and recapture by reinvesting sale proceeds in other real property within strict deadlines, identifying replacement property within 45 days and closing within 180 days. Ling and Petrova (2008) found that exchanges can be highly valuable to investors with large deferred gains, but that the benefit depends on finding suitable replacement property at a fair price. The family office will decide at sale.

Legal Diligence

Before closing, the buyer will obtain an owner's title insurance policy and a survey to confirm boundaries and easements, verify zoning permits the current density, review all leases and service contracts and commission a Phase I environmental site assessment to identify contamination that could make the owner liable under federal law.

Landlord-Tenant and Fair Housing

Texas law governs residential leases, including repairs, security deposits, which generally must be refunded with an itemized list of deductions within 30 days after a tenant surrenders the unit, and eviction procedures. The federal Fair Housing Act prohibits discrimination in renting and advertising, and the operator's leasing staff must be trained accordingly. The renovation will also need building permits.

Insurance and Liability

The partnership will carry property insurance at replacement cost, general liability and an umbrella policy, with the lender named as mortgagee. Texas has experienced severe hail and freeze losses, so policies may carry separate wind and hail deductibles of 2 percent or more of insured value. The operator must also follow lead, mold and smoke detector rules for residential rentals and keep records of repairs, since Texas law gives tenants remedies when landlords fail to repair conditions that affect health or safety after notice.

Property Tax Protests

Texas owners can protest appraised values each year. The operator will hire a tax consultant to protest after closing, since property taxes are the largest expense.

Conclusion

Depreciation, accelerated by cost segregation and 2025 bonus rules, turns Mission Oaks' early years into a large tax loss, usable only against passive income and largely recaptured at sale unless deferred through an exchange. Careful title, environmental and lease diligence and compliance with Texas tenant law and fair housing rules protect the investment, while annual tax protests manage its largest cost.

References

Brueggeman, W. B., & Fisher, J. D. (2018). Real estate finance and investments (16th ed.). McGraw-Hill Education.

Geltner, D. M., Miller, N. G., Clayton, J., & Eichholtz, P. (2014). Commercial real estate analysis and investments (3rd ed.). OnCourse Learning.

Ling, D. C., & Petrova, M. (2008). Avoiding taxes at any cost: The economics of tax-deferred real estate exchanges. The Journal of Real Estate Finance and Economics, 36(4), 367-404. https://doi.org/10.1007/s11146-007-9099-6