What is the tax shield, and how does it affect after-tax returns?

• A. It is the capital gains tax applied at sale.
• B. It is the reduction in taxes due to depreciation and interest deductions; increases after-tax cash flow and IRR.
• C. It is a deductible management fee.
• D. It is the tax charged on rental income above a threshold.

Answer: (B)

Tax shields come from deductions that lower taxable income, such as depreciation and mortgage interest. Because these deductions reduce the taxes you owe, they boost after-tax cash flow and the project’s IRR. In real estate, depreciation is a non-cash expense that lets you write off part of the property's value each year, shrinking taxable income without any actual cash outlay. Interest on the loan is deductible as well, further reducing taxable income. The annual tax savings from these deductions equals the marginal tax rate times the deductible amount, and that savings shows up as higher after-tax cash flow. So even if operating income is unchanged, after-tax returns rise because taxes are lower thanks to the shield.