About Real Estate Cash Flow

The objective behind any real estate investment is the cash flows produced by the property. Ask any rental income property owner: “Cash is king” when it comes to making investment decisions for both profit and rate of return.

Fair enough.

So in this article it seemed needful to discuss how cash flows are derived from a property along with why investors can only expect to permanently pocket just some of it after the Feds take their bite in taxes.  Hopefully it will help those of you who are new to real estate investing.

We’ll begin with a simple definition:  Real estate cash flow is all of a rental property’s revenue inflows less all of its outflows. In other words, it’s the cash that remains after all rents are collected and all expenses required to service and own the property are paid (i.e., the operating expenses and debt service).

Okay, but it should be understood that there are essentially two types of real estate cash flow commonly produced by rental income property. For our purposes we’ll categorize them as “ongoing” and “one-time” in order to draw a clear distinction that makes it easier to explain and understand.

Ongoing

Ongoing cash flows is the money received during the holding period as a result of renting space. In other words, it’s the money that results from the day-to-day operation of the rental property. If you think of it as all the money flowing in such as rent, loan proceeds and interest on bank accounts, less all the money flowing out like operating expenses, debt payment and capital additions you’ll get the idea.

It’s an “income stream” the rental produces during the time the investor owns the property. It can be regarded as a daily, weekly, monthly, annual or whatever stream. It can also result in an amount that is positive or negative (i.e., there’s money left over for the investor, or nothing left over that the owner must in turn supplement out-of-pocket).

One-Time

This is the cash flow that results due to a sale (or reversion) of the asset. In other words, this amount represents the “one time” cash revenue the investor collects when he or she transfers title to a buyer and no longer is the owner.

It is a one-time sales proceeds, and can also result in an amount that is positive (apt to lead to some congratulatory back-slapping) or negative (maybe none).

Okay, but that’s just the beginning. As stated earlier, both types of cash flows produced by investment real estate are subject to income taxes. So let’s step into it and take a look at how it all comes together.

Taxes

The on-going ongoing income streams are subject to annual income taxes. So in this case, we would consider these in one of two ways. Bear in mind, however, that we are speaking of taxes due “annually”, and therefore the formulations given below each reflect “annualized” amounts.

First, we have the real estate cash flow before taxes (or CFBT). This reflects the money an owner collects before tax liability. Therefore it is money subject to the investor’s annual Federal income taxes. The formulation here is fairly simple: net operating income less debt service.

Net Operating Income
– Debt Service
= CFBT

Secondly, we have the real estate cash flow after taxes (or CFAT). This provides the amount of money available to the investor after the IRS has been satisfied. This is typically of more important to the real estate investor because it represents the amount of spendable cash generated by the rental investment after deductions are made for taxes.

To arrive at this figure is slightly more complex than CFBT and does require several steps. Naturally, the property’s financial data and owner’s tax rate must be determined beforehand.

Net Operating Income
– Interest Paid on the Loan
– Depreciation Allowance
– Amortized Loan Costs
= Taxable Income
then,
Taxable Income
x Investor’s Tax Rate
= Income Tax Liability
then,
Cash Flow Before Taxes
– Income Tax Liability
= Cash Flow After Taxes

Okay, now let’s move on to the money an investor might collect one-time when he or she sells the rental property investment.

In this case, we must consider the sale proceeds before and after income taxes. It’s the same idea as before. Proceeds’s resulting from the sale are subject to taxation.

Therefore there are proceeds before tax that the investor may collect from escrow at the close of sale, and then the proceeds after tax that the investor can actually pocket when the taxes are paid.  Here’s the formulation in three steps.

Selling Price
– Costs of Sale
– Loan Repayment
= Sale Proceeds Before Tax
then,
Federal Tax on Sale
– Allowable Deductions at Sale
= Taxes due to Sale
then,
Sale Proceeds Before Tax
– Taxes due to Sale
= Sale Proceeds After Tax

Illustration

Here’s a sales proceeds report taken from one of the real estate investing software solutions provided by ProAPOD. (Click the image to enlarge).

real estate cash flow reversion

Final Thoughts

The key to forecasting real estate cash flow for a rental property you’re planning to purchase is to be realistic during your evaluation.

It’s always better to anticipate a small or negative cash flow you can handle with personal funds rather than to encounter a surprise after you purchase the property.

Avoid pie-in-the-sky rents and include all operating expenses when you conduct your rental property analysis. Remember, you’ll be paying for the real estate cash flow a property generates so be sure you know what it is most likely to be.

 

About Rental Property Cost Recovery (Depreciation)

Cost recovery, also commonly known as depreciation, is tax concept implemented by the Internal Revenue Service that is roughly defined by the tax code as a loss in value to a property over time as the property is being used.

Depreciation forms the basis for a major part of a real estate investor’s tax shelter during rental investment property ownership. And, in fact, depreciation deductions are one of the essential benefits of real estate investing.

In this article we’ll discuss this tax shelter method to give you the general idea of how it works. Including its application, as well as the various components and formulation to calculate depreciation allowance deductions.

Before we get started, though, allow me to point out I will be using the terms “cost recovery” and “depreciation” interchangeably in this discussion. However, each method is technically different. In fact the IRS introduced the more recent term “cost recovery” because of frequent issues that resulted from the previous term “depreciation.”

In actuality, however, it’s mostly a technical matter with differences that matter little to most taxpayers. So for our purposes, we’ll leave a more complete explanation to the qualified tax consultants and simply refer to both terms interchangeably.

Fair enough.

Application

The IRS regulates which types of real estate is eligible for depreciation, and therein it recognizes by the tax code to qualify for depreciation deductions, according to the following limitations.

  1. The property must be used in a trade or business or held for the production of income (an individual’s personal residence does not qualify)
  2. The property must have a determinable useful life longer than a year
  3. The property must be something that wears out, becomes obsolete, or losses its value from natural causes (the land component of the investment property cannot be depreciated)
When?

According to the tax code, depreciation can be applied to a real estate investment when the property is placed in service for a specified use; even if it is not immediately used for the intended purpose.

An entire apartment complex with several vacancies, for instance, would qualify for cost recovery because the units (though not fully occupied) are ready and available for use. Likewise, a new property may be considered in service when a certificate of occupancy has been granted.

Components

There are four components required to calculate the cost recovery deductions.

1. Basis

This is typically the original cost of the property plus capitalized costs of acquisition such as broker’s fees, appraisal fees, survey fees, title insurance, etc. As the investment is depreciated, the original basis minus accumulated depreciation results in an adjusted basis.

For example, a property purchased for $297,000 with acquisition costs of 3,000 would have an original basis of $300,000. Subsequently, accumulated depreciation would be deducted from that amount to calculate an adjusted basis.

2. Depreciable Basis (Cost Recovery Basis)

This is the overall basis minus the value of nondepreciable land. Since this must be justifiable, a good way to do this is by examining the tax assessments to see how they separate the value of the buildings from the value of the land. The dollar amounts they use may be less than the purchase price, but the proportion should prove meaningful.

For example, if the tax assessments are showing that the buildings for a rental property you are purchasing are 70% of its value, than it would likely be defensible for you to allocate $210,000 as a depreciable basis when paying $300,000 for the property.

3. Class and Cost Recovery Period

This determines the investment property’s class and appropriate recovery period. A property is classified as “residential” if 80% or more of the gross income is derived from dwelling units. This is considered by the IRS to have a useful life of 27.5 years. Rental property not classified as residential is classified as “nonresidential”. This is considered by the tax code to have a useful life of 39.0 years.

4. Date Placed in Service

This is the date the property is placed in service and determines the amount of first-year depreciation and the amounts for all future years in the holding period.

As stated earlier, an existing rental property is considered placed into service when the real estate investor takes ownership. A newly constructed apartment complex is considered placed into service when a certificate of occupancy is granted by the local code enforcement authority.

Formulation

Depreciable Basis / Useful Life = Depreciation Allowance (annual)

Example

Okay, let’s say you purchase an office complex and than draw the $210,000 depreciable basis we illustrated above.

$210,000 / 39 = $5,385 (annual Depreciation Allowance)

So You Know

ProAPOD provides two rental investment property software solutions that include cost recovery and automatically calculate annual depreciation allowance for both residential and nonresidential real estate investment property. Learn more at http://www.proapod.com

 

Some Real Estate Investment Terms Well Worth Knowing

There are virtually hundreds of real estate investment terms that can be discussed, and subsequently should be learned by real estate investors.

In this article, however, we’ll explain just six of the terms we consider play a major role with real estate investing but are not often understood by investors.

Our intent is not to present an exhaustive study. But rather to simply acquaint you with a general meaning of the more obscure real estate investment terms. The ones we feel are most worth knowing because they can affect your real estate investment’s profitability and rates of return.

Feasibility Study

A feasibility study examines the anticipated results from any specific real estate development or proposal. They are usually conducted to show the success potential of a project with the goal to enhance the developer’s chances to obtain financing, but can also be made for presentations before various public forums.

Highest and Best Use

The highest and best use of real estate signifies the best economic use of a property with respect to what is legally and physically possible at any given time. A change in zoning or other regulations may dramatically change the highest and best use. When a real estate investor can find and acquire a rental income property that can easily and economically be converted to the highest and best use, the property value can be increased dramatically.

Land Use Regulation

Land use regulation deals with how the land is used. Because most areas of the country have detailed land use rules that are frequently changed and have the effect of reducing land values, real estate investors would be wise to watch for public notification of these regulatory changes in the newspaper and attend the public forum.

Unincorporated Area

Real estate in an unincorporated area means that it outside legal city boundaries. These areas are governed solely by county government. Though property in the unincorporated area often have greater flexibility of use because county building and zoning rules are often more lax, they may not have all the public services available to other parts of the county.

Variance

A variance is an approval granted by the city or county commission to enable a property to be used contrary to one of the building codes or sometimes contrary to a zoning regulation. A variance may be easier to obtain than a complete change of zoning, but each circumstance will vary.

Zoning Board

A zoning board is usually compiled of appointed (non-elected) community leaders whose duties are to hear and vote on zoning issues within the community. They can give an investor advance information about the acquisition of a real estate investment property that could go up in value due to a proposed project and offer a good real estate investing opportunity.

So You Know

A more complete glossary of real estate investment terms can be found at real estate glossary of terms.

 

Having Issues with ProAPOD?

gross operating incomeProAPOD has been distributing real estate investment analysis software solutions to real estate agents and investors nationwide since 2000. During the majority of that time the program performed fluidly with out as much as a hiccup.

Starting with Microsoft Vista, however, the rules of engagement changed slightly, and now ProAPOD will require some minimal effort on the part of the user to function correctly.

Here’s the deal.

Starting with Vista, the guys at Microsoft figured that it would be better security for users who install Excel VBA programs like ProAPOD to have more hands-on control. As a result, some additional instructions for the user have been created.

ProAPOD has adequately provided these instructions for all the common issues (including text and screenshots) on its website at Customer Support.

Instructions are also provided inside the software solutions themselves. So every user who opens any ProAPOD solution is automatically greeted with a “Read Me” page to help ensure that users know what they must do up front.

None of the resolutions is difficult, takes more than a couple of minutes, and only needs to be dealt with one-time.

In this article I am posting links to each resolution for those common Windows issues along with some other issues sometimes caused by by the users themselves (i.e., pilot-error issues).

Windows Issues

How to Enable Macros
Nothing seems calculate or function. This is because you did not enable our VBA code to run. You must enable macros.

How to Grant File Permissions (video)
You get “read only” when trying to save. This is due to Vista and newer settings. You must now grant yourself file permissions to modify our program.

How to Grant File Permissions (article)

How to Display Our Toolbar
You aren’t getting the results you expected from the toolbar. This is because you are not using the toolbar provided by ProAPOD. You must use our toolbar for all commands.

Pilot-error Issues

You have downloaded and installed an update without having the “base” program installed on your computer and it won’t work correctly. You cannot run the program simply by downloading and installing an update. The update is only effective when the “base” program is already installed on the computer.

 

Rental Property Depreciation Recapture Tax

Depreciation recapture on rental property concerns a tax provision on capital gains due to depreciation commonly faced by real estate investors selling their rental income property.

In essence, depreciation recapture is the way the Internal Revenue Service is able to “recapture” taxes on all or part of the gain on the disposal of the asset as ordinary income rather than solely as capital gain (which is often at a lower rate).

The provision is far from simple. In fact determining the amount subject to recapture is typically characterized as one of the most confusing income tax liabilities confronting real estate investors selling rental property. Mostly because the specific rules are detailed and are subject do change.

So the following article intends to help you understand the general concept of depreciation recapture only. Investors must always consult with qualified legal and tax advisers when making any real estate investing decisions.

Okay, let’s walk through the process starting at the beginning.

Depreciation

The allowance for depreciation (or “cost recovery”) is one of the biggest tax-deduction advantages rental property owners are granted by the IRS during the course of their ownership.

According to the current internal revenue code, from the time real property is placed into service until the time the title is transferred or reaches the depreciable limit set by the IRS, investors can deduct an amount for cost recovery each year on the physical structures (called “improvements”) as an income tax deduction.

The amount of that annual deduction is determined by the asset’s “useful life” as specified in the code.  Currently the useful life for residential rental property (buildings occupied by tenants as housing) is 27.5 years and for non-residential rental properties (buildings occupied for business purposes) 39 years.

For example, say you purchase an apartment complex for $800,000 of which 70 percent is attributable to physical improvements. According to the IRS you would have a “depreciable basis” of $560,000 (800,000 x .70) which you can depreciate according to its useful life. In this case, by dividing that depreciable basis by useful life (560,000 / 27.5), you can claim a deduction for cost recovery to offset your taxable income each year in the amount of $20,364.

Please note that both the year of acquisition and year of sale would compute a slightly different amount due to the “mid-month convention” provided by the tax code. In the real world, of course, this convention would be considered, but for our purposes the convention is ignored just to keep it simple.

Fair enough. So let’s continue and show you why the Feds stepped in with depreciation recapture and IRS Code Section 1250 was created.

Depreciation Recapture

Since the taxpayer earned a benefit by offsetting ordinary income in owning depreciable rental property, the IRS concludes that the taxpayer must pay them back for that benefit when the property is sold.

Let’s consider an example to give you the idea. Assume that you sell your investment real estate at the end of five years for $900,000. Here’s how the internal revenue service determines your gain on the sale.

1. First, the total amount of deductions claimed during the holding period is computed by taking your annual deductions for depreciation by the number of years claimed (20,364 x 5), or $101,820.

2. Secondly, your “adjusted basis” is computed by lowering your original basis (purchase price) by the amount of deductions claimed (800,000 – 101,820), or $698,180.

3. Finally, your “gain” is computed by deducting the adjusted basis from sale price (900,000 – 698,180), or $201,820.

It’s worth noting how the IRS benefits from this method. For example, if your gain on sale was simply computed as sale price less your original basis (900,000 – 800,000), your gain would be $100,000. In this case, however, your gain increases to $201,820, which means that the IRS can collect taxes from you on an additional $101,820.

Okay, now let’s consider how the taxes are levied.

Since the tax on capital gain income is often less than taxes on ordinary income, rather than merely taxing the investor’s entire amount at the capital gains rate, the IRS instead applies depreciation recapture. This enables them to take the total deductions for depreciation claimed by the investor back into income and tax it as ordinary income.

Here’s how it works.

The $101,820 depreciation deductions taken by the real estate investor is taxed at the cost recovery recapture tax rate, and the remaining $100,000 (201,820 – 101,820) is taxed at the capital gains rate.

For example, if the recapture tax rate is 25% (the maximum allowable) and the capital gains tax rate is (say) 20%, the taxpayer would owe the Feds $25,455 (101,820 x .25) plus $20,000 (100,000 x .20), or $45,455.

Of course this tax method for depreciation recapture can cause a significant tax impact for real estate investors who sell rental properties. Consider this along with the illustrations above to see what I mean.

Without any consideration for depreciation deductions at all, the investor’s tax obligation at the time of sale would compute merely as selling price less purchase price (900,000 – 800,000), or $100,000 taxed at the capital gains rate (100,000 x .20), or $20,000.

Whereas with this consideration, the investor’s obligation to the IRS is based upon an increase to gain brought about by depreciation deductions and then taxed partially as ordinary income and capital gains, which, as we illustrated, results in a tax obligation of $45,455. In other words, the real estate investor’s obligation to the internal revenue by this method is increased by $25,455.

Okay, but even if we assume the higher adjusted gain of $201,820, we can still see how depreciation recapture impacts the investor. Without it, the investor’s obligation to the IRS would be based upon that entire amount taxed solely at the capital gains rate (201,820 x .20), thus resulting in a tax obligation of $40,364. With it partially taxed as recapture and the remainder as capital gains, however, the obligation becomes $45,455 (an increase of $5,091).

Just one more thought and we’re done.

Several conditions must be met at the time of a rental property sale for the depreciation recapture tax to be levied. The tax event takes place only at the time the asset is disposed. Secondly, the depreciable real estate must be sold after one year of ownership otherwise it is considered short-term capital gains and recapture doesn’t apply. Thirdly, the investor must show a recognized gain as a result of the sale (there is no recapture when the taxpayer takes a loss). Fourthly, the amount subject to recapture cannot exceed the gain realized and cannot exceed 25 percent.

Here’s to your real estate investing success.

So You Know

ProAPOD Real Estate Investment Software provides two solutions that include computations for depreciation recapture. Investor 8 real estate investor software and Executive 10 real estate investing software.