The Depreciation Allowance Mid-Month Convention

depreciation allowanceRental property depreciation allowance (or cost recovery) forms the basis for a major part of the tax shelter benefits real estate investors seek when investing in income property.

As a result, most of those making real estate investments are undoubtedly familiar with the term and its benefits. Yet they may not understand how the “mid-month convention” derived by the tax code is computed.

So in this article we’ll take a look at depreciation allowance and the mid-month convention.

Overview

According to the current tax code, those who purchase income property can take a depreciation deduction on the real property (the improvements, not the land) according to its useful life as prescribed by the tax code.

  • Residential rental property (27.5 years)
  • Non-residential rental property (39.0 years)

This means the annual depreciation for an apartment building would be about 3.6% of the cost of improvements. The annual deduction for non-residential property would be about 2.6%.

The depreciation allowance starts from the month the asset is placed into service (usually when title is taken) for use in a trade or business or for income production until whatever month the asset is disposed of. For example, if an investor takes title to a rental property in 1998 and sells it in 2012, then he would be eligible to take an annual deduction for depreciation for each of those years according to the appropriate depreciation schedule for the property.

Of course that’s fairly straightforward for the years the investor holds the property for a full twelve months (e.g., 1999 through 2011). But what about the year of purchase and then sale? Those would not typically equal a full twelve months ownership because both a purchase and sale would occur “inside” the month (resulting only in a portion of the month; not the full month).

To deal with this, the tax code also incorporates what is called a mid-month convention to whatever month you place the asset into service and whatever month you dispose of it. Here’s the idea.

Mid-month Convention

Rather than use the actual day of the month to begin or end the depreciation deduction allowance, the IRS simply assumes that the property is placed in service in the middle of the month when it was acquired and disposed of in the middle of the month when it is sold.

In other words, investors are entitled to one-half month’s depreciation in the month the income property was placed into service (regardless of the actual number of days in service for that calendar month), and one-half month’s depreciation in the month of disposition (regardless of the actual date of disposition).

For example, if the real estate investor procures the rental property on March 3, he would be given half a month’s credit for the month of March along with the remaining nine months in that year. He would be entitled to a depreciation allowance of nine and one-half months in 1998 (the year of purchase). Likewise, if he transferred title to the rental property on August 20, then he would be entitled to claim depreciation for half the month of August along with the previous seven months he held the property in 2012 (the year of sale).

So You Know

ProAPOD real estate investment software solutions Investor 8 and Executive 10 each apply the mid-month convention automatically for the depreciation allowance calculation.

 

Cash Flow After Tax {Video}

Cash flow after tax (CFAT) is one of essential returns real estate investors look for when doing a real estate analysis. In a nutshell, this represents the cash flow available to the investor after settling up with the IRS.

In the video below, ProAPOD’s iCalculator is used because it allows an easy and understandable way to present the cash flow after tax computation. A link to the page where you can learn more about iCalculator is provided below.
 

 

So You Know

Cash flow after tax is just one of many calculations you can make with iCalculator. To learn more about this unique online real estate calculator that teaches the formulas visit our website at real estate calculators.

 

Understanding Before and After Tax Real Estate Cash Flow

real estate cash flowReal estate cash flow is what every real estate investor is after when he or she shells out the money to make an investment in real estate.

This is pure real estate investing logic.

Namely, that no prudent real estate investor would ever make an investment in a rental property without some assurance that the cash flows produced by the real estate investment property will generate some amount of cash flow capable of yielding a favorable return on investment moneys spent.

Bear in mind, real estate investors are in the business of making money. That they invest in rental income properties to make money. As a result, their investment decisions are always contingent upon the amount of cash flow the rental property is expected to generate – whether monthly, annually or at the end of the day (when the property is disposed of).

Fair enough.

But it is also true that real estate cash flow is evaluated two ways depending on whether or not the investor’s income taxes are considered.

  • Cash flow before taxes
  • Cash flow after taxes

In this article we’ll summarize both real estate cash flow evaluations with their formulas so you at least get a general understanding how they are derived and why investors typically look at both when making an investment decision.

Overview

Real Estate cash flow is essentially all of the cash inflows produced by a real estate investment property less all of its cash outflows.

Cash inflows
– Cash outflows
= Cash flow

Think of it as all the money flowing in from the property such as rental and other incomes less all the money flowing out over the course of holding the property like operating expenses, debt payment, and capital additions and you’ll get the idea.

Explanation

Cash flow before tax (CFBT) doesn’t take into consideration the owner’s tax liability. In other words, it is the cash flow the real estate investor will collect from the investment property but will have to claim as income and therefore will still be liable to the IRS. This is usually what is meant when speaking about cash flow.

Net Operating Income
– Debt Service
– Capital Additions
+ Loan Proceeds
+ Interest Earned
= CFBT

Cash flow after tax (CFAT) does account for the investor’s tax liability and therefore represents the amount of money that the real estate investor will pocket after the IRS is paid and satisfied. Therefore it represents spendable cash from the investment. It concerns a separate tax calculation for tax liability (the investor’s obligation to the IRS based upon taxable income) but we will not discuss that in this article.

CFBT
– Income Tax Liability
=CFAT

Rule of Thumb

Creating a real estate analysis with both CFBT and CFAT is optional. But it’s generally true that serious real estate investors prefer to know what revenue they can expect to pocket after the IRS takes its tax bite, so it might be a good idea for you to account for both in your real estate analysis.

So You Know

ProAPOD automatically calculates CFBT and CFAT in both their Executive 10 real estate investing software and Investor 8 real estate investor software solutions.

 

iCalculator: A Smart Option for Hand-held Financial Calculators

iCalculatorHand-held financial calculators provide a credible way to make dozens of complex real estate calculations that otherwise would not be possible for typical users to make in their head.

Unfortunately, the downside to hand-held financial calculators is that they require a series of inputs and entries with a close eye on the instruction manual that can be both cumbersome and time consuming.

Calculating Net Present Value with five annual cash flows on an HP-10B, for instance, requires the user to clear the registers, set the number of payments per year, enter the initial cash flow, enter each of the separate cash flows plus number of occurrences, the interest rate, and then click the NPV button to calculate net present value of those stored cash flows.

According to my count that’s about eighteen separate keyboard selections – all of which will require some amount of time, an understanding of the calculator’s functions, and the risk of making a mistake and having to start over.

I struggled with this for years. And as a result, I decided to develop my own real estate calculator called iCalculator to mimic those types of real estate calculations made on financial calculators but with the ability to arrive at the result much easier and quicker.

With iCalculator you simply complete a user-friendly form and click Calculate to arrive at the result.

In the illustration provided below, for example, look how easy it is to arrive at the otherwise complex computation for net present value. Rather than a series of numerous keyboard selections required on hand-held calculators, you simply complete the form and Calculate.

iCalculator

So You Know

iCalculator makes dozens of real estate calculations with formulas. Web-based so you can access it 24/7 from any device that connects to the internet.  Save 64% by virtue of this article.  Retail is $79.95, you pay just $24.95. Learn more about iCalculator and save 64%

 

ProAPOD Software Solutions Updated!

ProAPOD Real Estate Investment Software has updated all three of its investment software solutions – Executive 10, Investor 8, Agent 6.

There are some changes to all three solutions that effectively are common to all three solutions, and some changes that are more specific to each solution. We’ll discuss both.

Common to All

  • A link to our online Help file has been added to Windows “All Programs” menu. This means you can open and read the Help file for your solution right from your desktop by clicking Start > All Programs > ProAPOD (or ProAPOD INVESTOR) > Help File (Online).

Specific to the Solution

Executive 10 – Agent 6
  • Corrected the Save function. Previous versions gave two prompts to Save when closing the program. This was redundant so we eliminated the second prompt. The result is a faster, more responsive Close.
  • Eliminated the ProAPOD SAVED FILES folder to resolve issues caused primarily by Vista. The update will not delete the folder if it already exists on your computer, so your saved projects are safe. We just don’t want future installations to include it. We recommend that all saved projects be saved in the primary ProAPOD folder.
  • Added a new desktop shortcut icon labeled “ProAPOD Files Folder”. This is intended to replace the previous “ProAPOD SAVED FILES” icon. Both point to the same folder so you are safe to delete the “ProAPOD SAVED FILES” icon.
Investor 8
  • Renamed the “ProAPOD INVESTOR” desktop shortcut to “ProAPOD Investor”. This was done for aesthetic purposes only because they both will open the program. You are safe to delete the previous “ProAPOD INVESTOR” desktop shortcut.
  • Added a new desktop shortcut labeled “ProAPOD Investor Files Folder”. This will allow you to access your saved projects from your desktop.

Although every effort has been made to insure the intended results for these modifications, please contact me immediately if you encounter a problem.

 

How to Calculate the Present Value of a Future Cash Flow

present-valueThe present value (PV) of a future cash flow (or series of cash flows) is calculated when you want to figure out what an income-producing property is really worth to you in today’s dollars.

The idea is fairly straightforward.

Money collected in a year or two will not have the same purchasing power it has today due to the time value of money.  That is, over time the value of money erodes, and therefore cannot be expected to purchase the same amount of goods and services in the future as it does today.

As a result, real estate investors must consider present value in order to solve the question, “What is a real estate investment worth to me today based upon the present worth of its future cash flows?”

The Method

PV might be easiest understood as the reverse of compound interest. Money deposited in a bank today, for instance, grows over time to some greater amount in the future because it is “compounding” at a specified interest rate. Whereas, PV would “discount” that future amount at the specified interest rate to arrive at the amount deposited today.

Here’s how it works for the purpose of our discussion.

  1. The real estate investor decides upon the desired rate of return he or she wants to earn from the property’s future cash flows
  2. Those future cash flows are then discounted at that rate of return to determine their present value
Formulation
  • PV = FV/(1 + r)n
  • Where r is the rate per period and n is the number of periods.
Example

As a simplified illustration, let’s assume that you’re looking at a rental income property you believe can be sold at the end of five years for a $700,000 gain. You want to know what price to pay for the property in order for that gain to yield you 11.0% annually.

  • $700,000 is the future value (FV)
  • 11.0% is the rate per period
  • Five years is the number of periods

If you run the calculation, you’ll see that the PV of that future amount is $415,416 (rounded).

In other words, if the investor pays $415,416 or less for the rental property he or she will get their desired rate of return. If they pay more, they will not.

Application

The illustration above hopefully makes the point regarding the importance to real estate investors about calculating PV.

What if, for instance, several different investment opportunities of similar risk were competing for the investor’s investment dollar. He or she would be unable to determine which investment would more likely yield his or her desired rate of return without the present value calculation.

So You Know

ProAPOD’s iCalculator real estate calculator was used to calculate the result in our example. This is just one of many calculations that can be made instantly (along with displaying the formula). You are entitled to a 64% discount on this online calculator. Learn more about iCalculator and the discount…