It is common for real estate investors and analysts to conduct a real estate analysis on investment property with full consideration of tax shelter in order to compute cash flow after tax because CFAT reveals the bottom line amount an owner might receive after the Feds take their cut.
Nonetheless, even with the popularity amongst real estate investors and most analysts seeking to know the cash flow after tax, there are some who simply want to the determine the cash flow that a property will generate before taxes. Fair enough. So exactly what is the difference between these two cash flows?
Understanding Cash Flow
Cash flow is that flow of funds that result from money coming in and money going out. In other words, all the income generated by the investment property less all of the expenses required to hold the property creates the cash flow.
When you take in more income then you pay out (i.e., money is leftover after all the bills are paid) the cash flow is “positive” and therefore available for you to take off the table and allocate elsewhere. On the flip side, if you spend more money than you take in it results in a “negative cash flow” that requires you to pull money from your own pocket (i.e., outside the property account) to make up the deficiency, therefore creating a vacuum you must fill without any hope of residential cash.
What is CFBT?
CFBT is an acronym for cash flow before tax and essentially means the cash generated by the property during any specific period that does not account for the impact that property ownership has upon the owner’s tax liability. In other words, though CFBT is an income that remains after payment for operating expenses and loans, it will have to be declared as “income” by the owner to the IRS and therefore is subject to taxation.
Here’s an example of how to compute it.
If a rental property produces a yearly gross operating income (i.e., rental income less vacancy allowance) of $54,720, with annual operating expenses of $21,888 and an annual mortgage payment of $24,174, then the annual cash flow before taxes (still subject to taxation) would be $8,658.
What is CFAT?
Cash flow after tax in essence means that the cash flows generated by the income property have been adjusted for taxes and as such does take into account any income tax liability that the owner encounters by reason of operating the property. The computation is clear-cut: Cash Flow Before Taxes less Income Tax Liability equals Cash Flow After Taxes.
Before we look at an example let’s consider what income tax liability is and how it gets computed.
Tax liability represents the amount of income produced by the property that is subject to taxation. In this case, the property’s net operating income (i.e., income less operating expenses) is first converted to taxable income. This is accomplished by taking the net operating income and deducting for depreciation, mortgage interest, and amortized loan points. Then the taxable income is multiplied by the investor’s marginal income tax rate (i.e., combined fed and state) to calculate the investor’s income tax liability.
Okay, let’s consider the following example.
Let’s assume that the property in question has a net operating income of $32,833, that the allowable deduction for depreciation taken that year totals $11,710, and based upon the current financing that deductions were taken that year for interest expense totaling $20,048 and amortized loan points totaling $112.
1) To begin with, we must first determine the taxable income. We do this by taking the net operating income of $32,833 and subtracting the total deductions taken of $31,870, which in turn results in a taxable income of $963.
2) Next, we compute the investor’s tax liability. We do this by multiplying the taxable income produced by the property by the investor’s marginal tax rate (which we’ll say is 38%). Therefore, 963 x .38 equals a tax liability of $366.
3) Lastly, we solve for the cash flow after tax by subtracting that tax liability of $366 from the cash flow before tax (or CFBT) of $8,658. So we take $8,658, subtract the $366, and we have determined that the cash flow after tax (or CFAT) is $8,292. It should be pointed out, though, that when the tax liability is a negative amount it would mean that by owning that property for that given year the investor lost money and is entitled to a tax write off. Therefore that loss (which equates to a tax savings) would be added to the cash flow before taxes.
Okay, now compare what the CFBT was to the CFAT so you can understand why this is important to real estate investors. Whereas before taxes, we were seeing a cash flow of $8,658, after the Feds take their cut we see $8,292. Granted, not that significant from our example, but you get the idea. There may be times when there is a significant difference. Therefore you would not want to invest in a rental property without full consideration of what the tax implications might be by owning that property.