Probabilistic Valuation Models and Income Tax Asymmetries with an Application to the Analysis of Passive Loss Restrictions

This paper develops a modified version of the standard real estate discounted cash flow valuation model that allows the analyst to specify probability distributions, rather than point estimates, on general inflation and rental income for each year of the expected holding period. Explicit modeling of rental income uncertainty is especially critical in the presence of restrictions that cause the tax treatment of income-producing property to be asymmetric. This is demonstrated by an analysis of the restrictions on passive activity losses (PAL) that were introduced with the passage of the Tax Reform Act of 1986. The probability model results indicate that rational investors can pay significantly more for an income property as a result of the elimination of PAL restrictions than would be indicated by the results produced by a standard discounted cash flow "point estimate" model. This is due to the reduction in the skewness of the after-tax returns generated by the property when PAL restrictions are eliminated, and the decline in the required equity discount rate that results from the decreased variance of the after-tax returns.