How to Compute Rental Property Cash Flow After Taxes (CFAT)

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Cash flow is the objective behind any real estate investing decision (and, of course, the more buckets full of it the better as far as most real estate investors are concerned).

The amount of cash flow a rental property generates is how real estate investors measure the worth of the investment. Cash flow is the bottom line. The definitive contributor to the investor's rates of return and profitability.

As such, without some production of cash flows (whether periodically or at a subsequent sale), the real estate investment would normally be regarded as a dismal financial failure.

This is the purpose behind a thorough real estate analysis. Real estate investors crunch the numbers in order to determine the amount of cash flow generated by the investment property. Then, based upon the numbers derived by that analysis, make their investment decision whether to buy or pass on the property.

Overview

Understand that rental properties generate two types of cash flow: Cash flow before taxes (CFBT) and cash flow after taxes (CFAT). Though both equate to real dollars, there is a significant difference.

CFBT is the cash produced by a rental investment property without any consideration for income taxes, and therefore becomes subject to state and federal taxes. CFAT, on the other hand, is the cash generated by a rental investment property that the real estate investor gets to keep after he or she meets their income tax obligation..

Most investors, of course, will consider both in their real estate analysis, but typically lean more heavily on knowing the amount of money they can pocket after the Feds take their cut (i.e., CFAT).

It seemed needful, therefore, to help you understand the method and calculation. We'll begin with the formulation, followed by the steps you must take to arrive at the result (including a description of some components that require clarity).

Formulation

Cash Flow Before Taxes
less Income Tax Liability
= Cash Flow After Taxes

Step 1: Calculate CFBT

We are showing a more detailed top-down calculation than perhaps necessary so those of you less familiar with real estate investing will understand how we arrive at net operating income (which is used later).

Formulation

Gross Scheduled Income
less Vacancy and Credit Loss
plus Other Income
= Gross Operating Income
less Operating Expenses
= Net Operating Income
less Debt Service
less Capital Additions
plus Loan Proceeds
plus Interest Earned
= Cash Flow Before Taxes

So You Know

For our purposes, we are dealing with the property's annual cash flow, therefore all amounts are based upon the period of a year.

Debt service is the total mortgage payment (both interest and principal). Capital additions are any improvements with a useful life of more than one year that are likely to increase the life of the property (i.e., not maintenance repairs). Loan proceeds refers to any financing the investor obtains to make the capital improvements. Interest earned is what the investor might have collected on any interim cash flows that earned interest (e.g., a bank deposit).

Step 2: Calculate Taxable Income

This represents the investor’s taxable income or loss which (as the name suggests) represents is the amount on which the investor must pay Federal income tax after consideration for the elements of tax shelter.

Formulation

Net Operating Income
less Interest Paid
less Depreciation
less Amortization
plus Interest Earned
= Taxable Income

So You Know

The current tax code allows owners of investment real estate to shelter some of its income from taxation, including the mortgage interest, depreciation, and amortized loan points.

Formulation

Depreciation Allowance (annual) = Depreciable Basis / Useful Life

where,

depreciable basis is the value of the improvements

The tax deduction for depreciation is based upon the the property's useful life as specified in the tax code and applies only to the physical structure (called "improvements", not to the land). The useful life is currently 27.5 years for residential property (e.g., an apartment building), and 39 years for nonresidential property (e.g., an office building).

The tax deduction for amortization is based upon the total amount of loan origination fees amortized over the term of the loan.

Step 3: Calculate Income Tax Liability

This determines the amount that the investor must pay in taxes. You simply multiply the taxable income computed in Step 2 by the investor's tax rate.

Formulation

Taxable Income
x Tax Rate
= Income Tax Liability

So You Know

The tax rate is typically the real estate investor's marginal tax rate (i.e., state and federal tax rates combined).

Step 4: Calculate CFAT

Okay, now you're ready for the final calculation. Here you take the CFBT computed in Step 1 and deduct the income tax liability computed in Step 3.

Formulation

Cash Flow Before Taxes
less Income Tax Liability
= Cash Flow After Taxes

So You Know

In cases where the real estate investor encounters a taxable income loss back in Step 3 (not a gain) then the income tax liability becomes a deductible savings which is "added to" and not "deducted from" cash flow before taxes to compute cash flow after taxes.

Formulation

Cash Flow After Taxes = Cash Flow Before Taxes + Income Tax Loss

So You Know

In cases where the real estate investor encounters a taxable income loss back in Step 3 (not a gain) then the income tax liability becomes a deductible savings which is "added to" and not "deducted from" cash flow before taxes to compute cash flow after taxes.

About the Author

James Kobzeff is a real estate professional and the owner/developer of ProAPOD - a leader in real estate investment analysis software solutions since 2000. All the formulations discussed in this article are automatically computed in both its Investor 8 and Executive 10 solutions. Learn more at real estate investing software solutions.

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