Deferred tax liabilities are future tax obligations that arise from timing differences between accounting and tax reporting. They affect a company’s equity by reducing net asset value and play a crucial role in valuation as they represent future cash outflows. This article dives into what deferred tax liabilities are in the context of commercial real estate companies, how they are created, and their treatment under different accounting standards like IFRS and US GAAP. We will also explore how deferred taxes are treated in valuation processes, including equity adjustments and DCF analysis, along with a closer look at leverage calculations.

What is a Deferred Tax Liability in Real Estate?

Deferred tax liabilities (DTLs) represent taxes that a company expects to pay in the future. In real estate, they arise due to differences between the tax basis of an asset and its book value on the balance sheet. Essentially, deferred tax liabilities emerge when tax laws allow for accelerated depreciation or when property appreciation is not immediately taxable. Note that since REITs are exempt from paying taxes, deferred tax liabilities are relevant only to real estate companies not structured as REITs.

For commercial real estate companies, deferred tax liabilities commonly arise due to the nature of tax deductions like accelerated depreciation, which reduces taxable income today but postpones the tax liability into the future. Over time, as the difference between accounting and tax values decreases, the deferred tax liability comes due. Additionally, as real estate asset values generally appreciate with inflation, their current value often exceeds the tax base.

In simple terms, think of deferred taxes like a postponed bill: today you get a tax break, but eventually, usually on sale of the asset. you will need to pay up. It’s important for analysts and investors to consider this liability, as it influences the company’s true value and can impact future cash flows.

How Deferred Tax Liabilities Are Created

Deferred tax liabilities in commercial real estate are generally created in two ways:

1. Accelerated Depreciation: Tax authorities often allow real estate companies to depreciate their assets more quickly for tax purposes than for accounting purposes. This creates a timing difference—the company pays less tax today, creating a deferred tax liability for future years when depreciation catches up.
2. Property Appreciation: When property values increase, the difference between the asset’s market value and its book value also contributes to deferred tax liabilities. Under tax regulations, this gain is not taxed until the asset is sold, which defers the tax liability.

To illustrate, imagine a real estate company purchases a building for $10 million. Under tax laws, they might depreciate the building at a faster rate, reducing taxable income. However, in their financial statements, they record a slower rate of depreciation. The difference between these two depreciation schedules leads to the creation of a deferred tax liability.

IFRS vs. US GAAP: Accounting Differences

The treatment of deferred taxes differs slightly between IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles).

• IFRS: Under IFRS, deferred tax liabilities are calculated based on the differences between the book value and the tax value of assets, since the book value represents the fair vlaue of the assets. For example, following is an excerpt form the financial reports of Vonovia, one of Europe’s largest real estate companies:
  Deferred tax liability was generated due to the appreciation in the value of the assets, comprising 17% of the balance sheet. 
• US GAAP: Under US GAAP, deferred tax liabilities are also based on timing differences, but there are specific rules that determine recognition. US GAAP tends to have more detailed guidance, and deferred tax liabilities are typically recognized only if it is probable that they will be realized.

1031 Exchange: Deferral of Tax on Property Sales in the US

In the United States, real estate companies can defer capital gains taxes through a mechanism known as the 1031 exchange. This allows property owners to defer paying capital gains tax when they sell a property, provided the proceeds are reinvested in a similar property. By using a 1031 exchange, companies can continue deferring their tax liability indefinitely, as long as they keep reinvesting.

For example, if a company sells a building and buys another within the guidelines of the 1031 exchange, they can defer the capital gains taxes that would otherwise be due. This is a common strategy in real estate that helps maintain cash flow while minimizing tax liabilities.

Calculating the Depreciated Asset Base and Deferred Tax Liability

To calculate the depreciated asset base, one must consider both the fair value of the assets and the deferred tax liability. The deferred tax liability is essentially the difference between the tax value of the asset and the book value, multiplied by the applicable tax rate.

For example, if a building has a fair value of $15 million and a tax base of $10 million, with a corporate tax rate of 20%, the deferred tax liability would be $1 million ($5 million difference x 20%). Conversely, if we know the fair value and the deferred tax liability, we can calculate the tax base. This calculation helps assess the deferred tax liability if the asset is assumed to be sold at a different value than the current fair value.

Deferred Tax Liability in Equity Adjustment Valuation

When valuing real estate companies, making adjustments to deferred tax liabilities is crucial. One approach often used is the adjustments to equity method, where analysts adjust the value of assets on the balance sheet.

In this approach, the value of deferred tax liabilities is usually calculated by:

1. Assessing the Asset Turnover Rate: Estimating how often assets will be sold or replaced.
2. Determining the Time Horizon: Estimating the number of years it will take for the assets to turnover.
3. Discounting the Deferred Tax Liability: Discounting the deferred tax liability to reflect its present value.

For example, if the deferred tax liability is EUR 100 million and the company does not typically sell assets, we assume they would be sold 20 years from now. We discount the EUR 100 million to its present value using a discount rate similar to the cap rate of the assets, for instance, 5%. This calculation results in the EUR 100 million deferred tax liability being valued at EUR 37.7 million. 

Typically, the value of the deferred tax liability is estimated to be between one-third and one-half of the amount reported on the balance sheet. This provides a more realistic view of what the company would actually owe, considering the time value of money.

Deferred Taxes in Discounted Cash Flow (DCF) Analysis

In a Discounted Cash Flow (DCF) analysis, deferred tax liabilities are treated differently depending on the assumptions about asset sales. When assuming perpetual income from current assets, deferred taxes are generally not factored in, as the assumption is that the assets will never be sold, and thus the tax is perpetually deferred.

However, if there is an assumption that an asset will be sold at some point, the relevant tax payment must be deducted from the sale proceeds. For example, if a property with a book value of $5 million is sold for $10 million, and the tax rate is 20%, then $1 million (20% of the gain) would need to be deducted from the proceeds to accurately reflect the cash flow impact.

EPRA Guidelines and Calculation of EPRA Net Asset Value

The European Public Real Estate Association (EPRA) provides a set of guidelines that enhance transparency and consistency in the real estate industry. One of the key metrics defined by EPRA is the calculation of the EPRA Net Asset Value (EPRA NAV), which provides stakeholders with more relevant information on the fair value of a company’s assets and liabilities. EPRA’s guideline is that if a company choose to disclose EPRA NAVs, it must report all three EPRA NAVs metrics:

EPRA Net Reinstatement Value: The objective of the EPRA Net Reinstatement Value measure is to highlight the value of net assets on a long-term basis. Assets and liabilities that are not expected to crystallise in normal circumstances such as the fair value movements on financial derivatives and deferred taxes on property valuation surpluses are therefore excluded. Since the aim of the metric is to also reflect what would be needed to recreate the company through the investment markets based on its current capital and financing structure, related costs such as real estate transfer taxes should be included.

EPRA Net Tangible Assets: The underlying assumption behind the EPRA Net Tangible Assets calculation assumes entities buy and sell assets, thereby crystallising certain levels of deferred tax liability.

EPRA Net Disposal Value: Shareholders are interested in understanding the full extent of liabilities and resulting shareholder value if company assets are sold and/or if liabilities are not held until maturity. For this purpose, the EPRA Net Disposal Value provides the reader with a scenario where deferred tax, financial instruments, and certain other adjustments are calculated as to the full extent of their liability, including tax exposure not reflected in the Balance Sheet, net of any resulting tax. This measure should not be viewed as a “liquidation NAV” because, in many cases, fair values do not represent liquidation values.

Deferred Taxes and Leverage Calculation

Deferred taxes can complicate leverage calculations. The inclusion or exclusion of deferred tax liabilities significantly affects leverage metrics like Debt to Capitalization.

Findings from Research: Interviews conducted in related research indicate a general consensus among practitioners that deferred taxes should be included in leverage calculations to avoid losing critical financial information. However, opinions differed on whether to include the entire deferred tax amount or just a part of it. Some participants suggested partially including deferred taxes, offsetting them against the cost of the asset generating the liability, while others believed that deferred taxes should either be fully included or excluded depending on the anticipated cash impact.

From a theoretical perspective, Professor Damodaran recommends including the value of deferred taxes in equity valuation, as they represent a liability that impacts the overall value available to equity holders. Practically, many REIT analysts prefer to calculate leverage ratios both with and without deferred taxes to provide flexibility and transparency for stakeholders.

Impact on Stakeholders: For debt holders, deferred taxes may be less relevant, as their primary focus is on whether the REIT can cover its debt through asset sales, even in scenarios where assets are sold below their listed value. In such cases, deferred taxes might not materialize, thus having little impact on immediate liquidity assessments. Debt analysts should evaluate whether deferred taxes would be paid if the assets are sold at values close to the face value of debt, as this affects their relevance to leverage. On the other hand, equity holders are more concerned with the potential future tax liability that deferred taxes represent, which directly affects the equity base and, consequently, their returns. Furthermore, since the cost of equity calculation involves leverage, it is customary to include deferred taxes in the calculation of leverage to ensure a comprehensive assessment of financial risk and provide a more accurate representation of equity valuation, as recommended by Professor Damodaran.

Summary

• Deferred taxes represent future obligations that can impact valuation and financial metrics.
• They are created due to timing differences in depreciation and property appreciation.
• The 1031 exchange allows deferral of capital gains taxes on property sales in the US.
• In equity valuation, deferred tax liabilities are adjusted based on asset turnover rates, time horizons, and discounting.
• Deferred taxes are treated differently in DCF analysis depending on whether asset sales are assumed.
• Including or excluding deferred taxes affects leverage calculations, influencing metrics like Debt to Capitalization. The consensus is that deferred taxes should be included in leverage calculation.

Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. The full disclaimer can be found here.