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.
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 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).
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.
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
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
x Investor’s Tax Rate
= Income Tax Liability
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.
– Costs of Sale
– Loan Repayment
= Sale Proceeds Before Tax
Federal Tax on Sale
– Allowable Deductions at Sale
= Taxes due to Sale
Sale Proceeds Before Tax
– Taxes due to Sale
= Sale Proceeds After Tax
Here’s a sales proceeds report taken from one of the real estate investing software solutions provided by ProAPOD. (Click the image to enlarge).
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.