Accounts carry latent capital gains tax in full and undiscounted; a buyer should deduct what the fund is likely to pay, when it is likely to pay it.
Deduct the tax the fund is expected to pay, discounted to today, not the liability in the accounts. An illustrative fund with 80.0 million of latent gain taxed at 25 per cent carries 20.0 million of deferred tax. If it is likely to exit in five years, with a 40 per cent chance of an asset sale and otherwise a share sale that concedes 40 per cent of the tax to the next buyer, the expected present value at 8 per cent is 8.71 million: NAV rises from 150.0 to 161.29 million, 7.53 per cent.
Worked in full in The Real Estate Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Deferred tax on revaluation gains is often the largest liability in a real estate fund after its debt, and the most arbitrary. The accounts book it in full and undiscounted, as if every building were sold on the balance sheet date. Real estate funds rarely exit that way. A secondary buyer who takes the accounting figure overpays the discount; one who ignores it overpays the asset.
| Input | Value |
|---|---|
| Property at fair value | 300.0 |
| Tax base of the property | 220.0 |
| Latent gain | 80.0 |
| Tax rate on the gain | 25% |
| Deferred tax liability under IFRS | 20.0 |
| NAV reported under IFRS | 150.0 |
| Expected exit | 5 years |
| Probability of an asset sale | 40% |
| Probability of a share sale | 60% |
| Tax conceded to the next buyer in a share sale | 40% |
| Discount rate | 8.0% |
Expected tax = [passet × DTL + (1 − passet) × s × DTL] ÷ (1 + r)n
Adjusted NAV = IFRS NAV + DTL − expected tax
s is the share of the tax conceded in a share sale. In Excel, with the liability in B1: =(0.4*B1+0.6*0.4*B1)/1.08^5.
Step 1: the nominal liability. (300.0 − 220.0) × 25% = 20.0, the figure in the accounts. IAS 12 does not allow it to be discounted.
Step 2: the asset sale. If the property company sells the building in year five, the full 20.0 is paid then. Today it is worth 20.0 × 1.08−5 = 20.0 × 0.6806 = 13.61.
Step 3: the share sale. If the fund sells the company, the company's tax base passes to the buyer, who asks for 40 per cent of the latent tax off the price: 8.0 in year five, 5.44 today.
Step 4: weight the two. 40% × 13.61 + 60% × 5.44 = 5.44 + 3.27 = 8.71, 43.6 per cent of the nominal liability.
Step 5: adjust NAV. 150.0 + 20.0 − 8.71 = 161.29. The add-back is 11.29, 7.53 per cent of reported NAV. On a 10 per cent interest, 15.00 of reported NAV becomes 16.13.
The deferred tax is 6.67 per cent of property value but 13.33 per cent of NAV, because the fund is geared: every error in the liability is twice as large measured against the equity. Suppose the 10 per cent interest is offered at 8 per cent below reported NAV, 13.80. Against the adjusted NAV of 16.13 that is a discount of 14.44 per cent. Against a NAV with the tax removed altogether, 17.00, it is 18.82 per cent. A seller's adviser quoting the larger number and a buyer's committee using the reported one are both describing the same price.
| Tax conceded in a share sale | Exit in 3 years | 5 years | 8 years |
|---|---|---|---|
| 0% | 6.35 | 5.44 | 4.32 |
| 25% | 8.73 | 7.49 | 5.94 |
| 40% | 10.16 | 8.71 | 6.92 |
| 60% | 12.07 | 10.34 | 8.21 |
| 100% | 15.88 | 13.61 | 10.81 |
| Probability of asset sale | Expected tax | Adjusted NAV |
|---|---|---|
| 0% | 5.44 | 164.56 |
| 40% | 8.71 | 161.29 |
| 70% | 11.16 | 158.84 |
| 100% | 13.61 | 156.39 |
Across every cell the deduction is between 4.32 and 15.88, all below the 20.0 the accounts carry. The exit route matters more than the timing: moving from a certain share sale to a certain asset sale changes NAV by 8.17; three more years before exit change it by only 1.80. That makes it a diligence question, not a modelling one: what does the fund documentation say about exit, how has this manager sold before, and does the structure allow a share sale at all.
Tax rates, the treatment of share sales and the practice of conceding latent tax differ widely by country and over time. Every figure here is illustrative; the probabilities are a buyer's judgement and should be written down as such.
The book's net asset value is rebuilt layer by layer, and the discount bridged to value, in the free workbooks for this case.
Because IAS 12 prohibits discounting deferred tax. The liability is measured at the full rate on the full latent gain, as if the properties were sold on the balance sheet date. On a gain of 80.0m at 25 per cent that is 20.0m, even when the fund intends to sell in five years and to sell shares rather than buildings.
Yes, because it is paid at exit, not today. Undiscounted, the expected tax in the example is 12.80 million; at 8 per cent over five years it is 8.71, at 6 per cent 9.56 and at 10 per cent 7.95. A rate close to the return the buyer requires on the fund interest is consistent, since the tax comes out of the equity's exit proceeds; a lower rate is the conservative choice when the exit date is uncertain.
No. Adding the whole liability back values the interest as if exit were tax-free. On the example, NAV with no tax at all is 170.0m, 5.40 per cent above the 161.29m that reflects the expected tax. A price that looks like a 14.44 per cent discount on the adjusted figure looks like 18.82 per cent on the tax-free one.
This article is one calculation from The Real Estate Secondaries Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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