The amount of cash flow a real estate investor can collect from a rental property is what generally determines whether or not the investor made a prudent real estate investment decision because investors buy cash flow.
Here's how it works. Prior to an acquisition an investor typically evaluates a real estate analysis created for the property that breaks down the financial data. Upon review, if the numbers appear profitable, the investor proceeds with the investment, otherwise he or she moves on.
But it should also be noted that the cash flow generated by an income property is calculated in two ways related to the owner's federal income taxes:
- Cash flow before taxes (CFBT) - The amount of revenue collected after all expenses associated with the property are paid but still subject to taxes.
- Cash flow after taxes (CFAT) - The amount of revenue that the real estate investor collects and can actually pocket after the IRS takes its share.
Although most of you who have had some exposure to real estate investing are probably already familiar with the calculation for CFBT, you might not for the CBAT calculation. So let's walk through the process. There are six steps.
Step 1. GOI
Gross Scheduled Income
– Vacancy allowance
= Gross Operating Income
Note: Gross scheduled income represents the annual amount collected as if all units are rented. Vacancy allowance is the amount of rental income lost during the year due to empty units.
Step 2. NOI
Gross Operating Income
- Operating Expenses
= Net Operating Income
Note: Operating expenses is the annual amount of money paid by the owner to keep the rental property in service (i.e., property tax, insurance, trash and utilities, maintenance and repairs, and so on).
Step 3. CFBT
Net Operating Income
- Debt Service
= Cash Flow Before Taxes
Note: Debt service is the annual principal and interest mortgage payment.
Step 4. Taxable Income
Net Operating Income
- Interest expense
- Amortized loan points and closing costs
= Taxable Income
Note: Interest expense is the interest portion of the loan payment. Depreciation is the annual deduction taken by the investor according to what the tax code prescribes as the investment property’s useful life (i.e., 27.5 years for residential and 39 years for non-residential). Loan points are the premium paid to obtain the loan and must be amortized over the term of the loan. Closing costs are those paid to acquire the property and usually are amortized over the same number of years as the property’s useful life.
Step 5. Tax Liability (Savings)
x Marginal tax rate
= Tax liability (or savings)
Note: Marginal tax rate represents the real estate investor’s combined State and Federal income tax bracket. Tax becomes a liability when the amount is positive and a savings when it’s negative.
Step 6. CFAT
Cash flow before taxes
- Tax liability or,
+ Tax savings
= Cash flow after taxes
Note: Tax liability is what the investor must pay the IRS for the benefit of owning the property and therefore must be a deduction from cash flow, and tax savings is money lost as a result of ownership and therefore becomes an additional income tax write off for the investor that is added to the cash flow.