After-tax IRR is a set of cash flow rows, not a haircut on the pre-tax answer. Depreciation and recapture explain why the gap is smaller than the tax rate.
After-tax IRR is the IRR of the equity cash flows after the tax each year and the tax on sale: taxable income is NOI less interest less depreciation, and the sale gain is split between depreciation recapture and capital gain. On an illustrative 20,000,000 US property with a 12.47 per cent pre-tax levered IRR, the after-tax IRR is 9.77 per cent, an effective tax of 21.6 per cent of the return, well below the 37 per cent ordinary rate a quick haircut would apply.
Worked in full in Real Estate Financial Modeling by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A pre-tax property model ignores two things that move the after-tax answer in opposite directions. Depreciation is a non-cash deduction that shelters part of the operating income at the ordinary rate, and that saving arrives every year. On sale, the same depreciation lowers the tax basis and comes back as gain, taxed at a capped recapture rate rather than the ordinary rate, years later. Deferral plus a lower rate on the way out is why property is tax-efficient, and it is why the tax line belongs inside the cash flow, not applied to the IRR at the end.
| Input | Value |
|---|---|
| Price / land share (not depreciable) | 20,000,000 / 20.0% |
| Building basis / straight-line life | 16,000,000 / 39 years |
| Loan, interest-only / rate | 12,000,000 (60.0% LTV) / 6.00% |
| Year 1 NOI (6.50% cap rate) / growth | 1,300,000 / 3.0% |
| Hold / exit cap on year 8 NOI / selling costs | 7 years / 6.75% / 2.0% |
| Tax rates: ordinary / depreciation recapture / capital gain | 37.0% / 25.0% / 20.0% |
Non-residential real property is depreciated straight line over 39 years under US rules, and the gain attributable to that depreciation (unrecaptured section 1250 gain) is taxed at a maximum of 25 per cent. The rates above are top federal rates used for illustration; the 3.8 per cent net investment income tax and state taxes are left out, and depreciation is taken for full years rather than under the mid-month convention.
Depreciation = 16,000,000 ÷ 39 = 410,256 a year; interest = 12,000,000 × 6.00% = 720,000
Year 1 taxable income = 1,300,000 − 720,000 − 410,256 = 169,744; tax at 37.0% = 62,805
Year 1 after-tax cash flow = 580,000 − 62,805 = 517,195
| Year | NOI | Pre-tax cash flow | Taxable income | Tax | After-tax cash flow |
|---|---|---|---|---|---|
| 1 | 1,300,000 | 580,000 | 169,744 | 62,805 | 517,195 |
| 3 | 1,379,170 | 659,170 | 248,914 | 92,098 | 567,072 |
| 5 | 1,463,161 | 743,161 | 332,905 | 123,175 | 619,987 |
| 7 | 1,552,268 | 832,268 | 422,012 | 156,144 | 676,124 |
Seven years of operating tax total 758,280. Without depreciation the investor would pay 37 per cent on the whole pre-tax cash flow; the deduction saves 151,795 a year.
Sale = 1,598,836 ÷ 6.75% = 23,686,460; net of 2.0% costs = 23,212,730
Adjusted basis = 20,000,000 − 7 × 410,256 = 20,000,000 − 2,871,795 = 17,128,205
Gain = 23,212,730 − 17,128,205 = 6,084,525, of which recapture 2,871,795 and capital gain 3,212,730
Tax on sale = 2,871,795 × 25.0% + 3,212,730 × 20.0% = 717,949 + 642,546 = 1,360,495
Equity back after loan and tax = 23,212,730 − 12,000,000 − 1,360,495 = 9,852,236
Each year's 410,256 of depreciation saved 151,795 at 37 per cent and costs 102,564 at 25 per cent on sale: the investor keeps the difference and the use of the money in between.
Pre-tax: −8,000,000, then 580,000 rising to 832,268, plus 11,212,730 in year 7: IRR 12.47%, multiple 2.02x
After-tax: −8,000,000, then 517,195 rising to 676,124, plus 9,852,236 in year 7: IRR 9.77%, multiple 1.75x
Excel: =IRR(after_tax_equity_flows), with the tax lines built row by row, not =IRR(pre_tax)*(1-37%)
Tax takes 2.70 points off the IRR, 21.6 per cent of the pre-tax return, for a total tax bill of 2,118,775 of which 64.2 per cent is paid on sale.
| Case | Pre-tax IRR | After-tax IRR |
|---|---|---|
| Full model, 7-year hold | 12.47% | 9.77% |
| Shortcut: pre-tax IRR × (1 − 37%) | 12.47% | 7.85% |
| Shortcut: pre-tax IRR × (1 − 20%) | 12.47% | 9.97% |
| Depreciation left out entirely | 12.47% | 8.92% |
| Recapture taxed at 20% instead of 25% | 12.47% | 9.94% |
| 5-year hold | 11.85% | 9.11% |
| 10-year hold | 12.78% | 10.23% |
The longer the hold, the larger the share of the return the investor keeps, 76.9 per cent at five years and 80.0 per cent at ten, because the tax due on sale, recapture included, is deferred further while the depreciation shield keeps working each year. An investor in a lower bracket, at 24.0 per cent ordinary, gets 10.18 per cent.
Applying one tax rate to the pre-tax IRR. At the ordinary rate it understates the return by almost two points (7.85 against 9.77 per cent); at the capital gains rate it overstates it. The second mistake is forgetting recapture: taxing the whole gain at 20 per cent flatters the IRR to 9.94 per cent. The third is depreciating the land. Build the taxable income line, the basis roll-forward and the split of the gain in the model itself, next to the levered and unlevered cash flows, and the after-tax IRR falls out with them.
Illustrative, not tax advice. Real cases need passive activity rules, interest limitation elections, state taxes, cost segregation and the investor's own position; a 1031 exchange changes the exit line entirely.
An after-tax IRR is a separate set of cash flow rows, not a haircut: tax on NOI less interest less depreciation each year, and on sale recapture at 25 per cent and the rest at 20 per cent. Here that turns 12.47 per cent into 9.77. The book builds property models line by line with a separate returns sheet, and the free workbook for this kind of model has the rows to add the tax block to.
In the US the gain attributable to straight-line depreciation on real property, unrecaptured section 1250 gain, is taxed at a maximum of 25 per cent, and the rest of the gain at capital gains rates. In the worked example 2,871,795 of recapture costs 717,949 and 3,212,730 of capital gain costs 642,546 at 20.0 per cent.
No. Depreciation shelters operating income at the ordinary rate and is recaptured later at a lower rate, so the effective tax on the return is much lower. In the worked example the full model gives 9.77 per cent after tax; the pre-tax 12.47 per cent times one minus 37 per cent gives 7.85.
Usually, because the tax on recaptured depreciation is deferred further. In the worked example the investor keeps 76.9 per cent of the pre-tax return over five years and 80.0 per cent over ten, with after-tax IRRs of 9.11 and 10.23 per cent.
This article is one calculation from Real Estate Financial Modeling. 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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