The industry standards for measuring returns to real estate investments are rate of return on equity and cash flow. To do this successfully, however, the calculation of annual cash flow must be made in a series of steps with meaningful data for gross scheduled income (all rental income from the investment), vacancies and bad debts (based upon the experience of the subject property and current market conditions), operating expenses, and financing consideration.
For our purposes, we will defer the other aspects of the calculation to another discussion and focus strictly on the operating expenses associated with a rental property because it is commonly misunderstood by those engaged in the real estate investment analysis process.
Operating expenses are those expenses necessary to maintain and keep a rental property investment in service. For example, maintenance and repair costs, property taxes, insurance, management fees, water and sewer, utilities, garbage collection, landscaping costs, pool service, telephone, and advertising. They are not the mortgage payment (i.e., debt service) or personal income tax payment. Debt service is later deducted to calculate cash flow before taxes (CFBT), and income taxes the cash flow after taxes (CFAT), but don’t mistake them as expenses required to keep the investment in service.
Here’s the schema:
Gross Scheduled Income – Vacancy = Gross Effective Income
Gross Effective Income + Other Income = Gross Operating Income
Gross Operating Income – Operating Expenses = Net Operating Income
Net Operating Income – Debt Service = CFBT
CFBT – Income Taxes Payable or (tax savings) = CFAT
Operating expenses must be accurately accounted for income tax purposes also. For example, certain expenses may be paid by tenants under a net lease agreement and therefore must be offset by an appropriate addition to income. If tenants under a net lease agreement, for instance, reimburse you five hundred dollars a year for maintenance and repair costs then that amount would be included as income (in effect neutralizing the expenses’ impact on net operating income for that given year).
Moreover, expenses for the operation of rental property must be distinguished from expenditures for capital improvements. Capital improvements are defined as expenditures that will lengthen the life of an improvement, make it more useful, or increase the value of the property. In this case, the IRS tax code states that that improvement must be capitalized and then depreciated (not deducted in full for the year it was expended).
There is, however, a gray area (not unlike most tax issues) between the two definable extremes. For example, if a hand full of shingles is replaced to repair the roof on a rental property in order to keep the roof from leaking, it may fall under the definition of an operating expense. However, if the same number of shingles were used to replace one section of the roof exposed to wear and tear by weather elements, the expenditure may be regarded as extending the life of the roof, and therein might not be classified as a repair, but a capital improvement.
Another potentially troublesome allocation is that of reserves for replacements. In a planning sense this is a proper allocation of cash flow because it enables investors to make annual allowances for anticipated future expenses. However, from a tax shelter standpoint any allocation of funds in anticipation of future expenses cannot be deducted under federal tax code until they are incurred and paid.
As a real estate investor, these tax shelter implications are, of course, significant. Whereas expenditures classified as an operating expense could be deducted in the year of the expenditure, those classified as a capital improvement must be depreciated over the appropriate life of the improvement. So always seek good tax counsel if you own real estate investment property.
You can preview an APOD and other reports that reveal the cash flow schema on the website that I maintain for my real estate investment software. Simply open the Reports section of any of my three real estate investment software solutions. You will find numerous rental property analysis reports that you can freely preview.