How to Compute Taxable Income or Loss to Arrive at Cash Flow After Tax…
The profitability of a rental income character, of course, is measured by the amount of cash flow the character generates. What a real estate investor always wants to know when considering his or her profitability from the character for any given year is How much did I make? And this is resolved by considering the characters cash flow plus or minus the investors taxable income or loss.
To compute taxable income or loss we must first determine the characters net operating income (NOI). Net operating income is gross operating income less operating expenses. For example, say a rental character generates an annual rental income of $205,993 and annual operating expenses of $41,718 in: The NOI would be $164,275.
From that amount we then would deduct the annual amounts for loan interest paid, depreciation and amortization, and then add in any interest earned to compute the taxable income or loss.
Okay, lets break it down and then show the formula. It will be more meaningful that way.
The annual amount of interest paid on your loan during any given year is straightforward. Say, for example, that you made mortgage payments totaling $88,470 of which $23,552 was applied to principal: The amount of interest paid during that year was $64,918.
Depreciation is more complicate because it depends on the kind of real estate being depreciated and what percent is allocated to improvements (land cannot be depreciated).
Depreciation (or cost recovery) is defined by the tax code as a loss in value to a character over time as the character is being used and owners are allowed by the tax code to take a tax deduction each year until the complete asset is written off. The amount of depreciation deduction depends on the income characters useful life which the current tax code says is 27.5 years for residential character and 39 years for commercial (nonresidential character) real estate.
For our example well keep it simple and just say that the amount of allowable depreciation taken for our income character during this given year was $23,076.
This refers to the time of action of taking a uncompletely annual tax deduction for an item you are not allowed to expense in a single year and must amortize, such as loan points. Though you pay this premium in a lump sum the minute you close the loan you are required to amortize it over the life of the loan.
Again (for simplicity sake) lets just assume that the amortized points allowable by the tax code for our given year were $920.
This concerns the interest income you might have earned on your income character or maybe on an escrow account that your lender required for real estate taxes and insurance.
In this case well simply assume that the interest earned is zero.
Fair enough. Now that you have some idea of what these elements represent lets look at the formula.
Net Operating Income
less Interest Paid
plus Interest Earned
equals Taxable Income or Loss
How to Arrive at Cash Flow After Taxes
There are essentially two cash flows generated by rental income character: That which is produced without any consideration for income taxes, and that which results after the investor meets his or her income tax obligation.
The former is known as cash flow before taxes (CFBT) and is derived by subtracting the characters annual debt service from its net operating income. For example, by subtracting the total mortgage payments of $88,470 illustrated above from the NOI of $164,275 the CFBT is $75,806. This figure is typically shown in a real estate examination and plays a part in our next computation, but it really doesnt represent the cash the investor gets to pocket after Uncle Sam has taken his bite.
That brings us to a more meaningful bottom line known as cash flow after taxes (CFAT), and explains why its basic to compute taxable income and loss.
The formula is comparatively straightforward:
Cash Flow Before Taxes (CFBT)
less Income Tax Liability
= Cash Flow After Taxes (CFAT)
Okay, now lets break it down.
The income tax liability is computed by multiplying the taxable income or loss by the investors marginal tax bracket. For example, say that the investor falls into a 28% tax bracket. We would multiply $75,361 by.28 to arrive at an income tax liability of $21,101 which in turn is subtracted from CFBT to compute CFAT. In other words,
Fair enough, but how do we manager a taxable income loss? for example, say that the taxable income we computed earlier was a negative $75,361, what then? In that case the income tax liability results in a negative $21,101 and is additional to the CFBT which in turn increases the CFAT.