Sam Johnson inherited $85,000 from his father. Sam is considering investing the money in a house, which he will then rent to tenants. The $85,000 cost of the property consists of $17,500 for the land, and $67,500 for the house. Sam believes he can rent the house and have $8000 a year net income left after paying the property taxes and other expenses. The house will be depreciated by straight-line depreciation using a 45-year depreciable life.
(a) If the property is sold at the end of 5 years for its book value at that time, what after-tax rate of return will Sam receive? Assume that his marginal personal income tax rate is 34% for federal and state taxes.
(b) Now assume there is 7% per year inflation, compounded annually. Sam will increase the rent 7% per year to match the inflation rate, so that after considering increased taxes and other expenses, the annual net income will go up 7% per year. Assume Sam's marginal income tax rate remains at 34% for all ordinary taxable income related to the property. The value of the property is now projected to increase from its present $85,000 at a rate of 10% per year, compounded annually. If the property is sold after 5 years, compute the rate of return on the after-tax cash flow in actual dollars. Also compute the rate of return on the after-tax cash flow in Year-0 dollars.