The profitability of investment real estate property, of course, is measured by the amount of cash flow the property generates. What a real estate investor always wants to know when considering his or her profitability from the property for any given year is “How much did I make?”
And this is resolved by considering the property’s cash flow plus or minus the investor’s taxable income or loss.
Taxable Income or Loss
To make this computation we must first determine the property’s net operating income (NOI). Net operating income is gross operating income (GOI) less operating expenses. For example, where a rental property generates an annual rental income of $205,993 and annual operating expenses of $41,718, its net operating income would be $164,275.
GOI – Operating Expenses = NOI
$205,993 – 41,718 = 164,275
Next, we would then deduct the annual amounts for loan interest paid, depreciation and amortization, and then add in any interest earned to arrive at the investor’s taxable income or loss. Okay, but let’s break down the various components 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. For instance, if you made mortgage payments totaling $88,470 of which $23,552 was applied to principal, the amount of interest you paid during that year is $64,918.
Payments made – Principal reduction = Interest Paid
$88,470 – 23,552 = 64,918
Depreciation is more complex because it depends on the type 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 property over time as the property is being used” and owners are allowed by the tax code to take a tax deduction each year until the entire depreciable asset is written off. The amount of depreciation deduction depends on the income property’s “useful life” which the current tax code says is 27.5 years for residential property and 39 years for commercial (nonresidential property) real estate.
For our example we’ll keep it simple and just say that the amount of allowable depreciation taken for our income property during this given year was $23,076.
Depreciation taken = $23,076
This refers to the process of taking a partial 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) let’s just assume that the amortized points allowable by the tax code for our given year were $920.
Amortization = $920
This concerns the interest income you might have earned on your income property or maybe on an escrow account that your lender required for real estate taxes and insurance. In this case we’ll simply assume that the interest earned is zero.
Interest Earned = 0
Net Operating Income
– Interest Paid
+ Interest Earned
= Taxable Income or Loss
Cash Flow After Taxes
To arrive at the investor’s cash flow after taxes (CFAT) we must consider two other components that must be calculated first. Namely, cash flow before taxes (CFBT) and tax liability.
Cash Flow Before Taxes
This represents the income produced by the property without any consideration for the real estate investor’s income taxes. It is derived by subtracting the property’s annual debt service from its net operating income. For example, by subtracting the total mortgage payments of $88,470 (or debt service) illustrated above from the NOI of $164,275 the CFBT is $75,806.
NOI – Debt Service = CFBT
$164,275 – 88,470 = 75,806
This amount is typically shown in a real estate analysis and plays a part in our next computation, but it really doesn’t represent the cash the investor gets to pocket after Uncle Sam has taken his bite.
Income Tax Liability
This represents what the real estate investor will owe to the IRS for income tax purposes by virtue of owning the real estate investment. It is computed by multiplying the taxable income or loss by the investor’s marginal tax bracket. For example, if the investor falls into a 28% tax bracket then we would multiply $75,361 by .28 to arrive at an income tax liability of $21,101.
Taxable Income or Loss x Marginal Tax Rate = Income Tax Liability
$75,361 x .28 = 21,101
That brings us to the more meaningful bottom line of cash flow after taxes – the amount of cash the real estate investor can keep after income tax – and explains why it’s essential for investors to determine.
– Income Tax Liability
We illustrated a positive taxable income and therefore an income tax liability that reduced the CFAT. If it were a negative amount it would be considered a taxable income loss which means that the income tax liability would in turn increase the CFAT.
So You Know
ProAPOD Real Estate Investment Software provides two solutions that automatically make these calculations and includes them in the appropriate real estate analysis reports.