Cash Flow Before and After Tax: The Computations and Importance To a Sound Real Estate Analysis
Real estate investors and real estate investing analysts generally seek to know the cash flow after tax (CFAT) when evaluating the profitability of investment income properties during a real estate analysis because it includes the elements of tax shelter and shows the cash an owner might expect to receive from a property after Uncle Sam takes His cut.
Nonetheless, even with the popularity amongst real estate investors and most analysts seeking to know the cash flow after tax, there are some who simply want to the determine the cash flow that a property will generate before taxes. Fair enough. So exactly what is the difference between these two cash flows?
What is Cash Flow?
Cash flow is what remains after the money that goes out to pay the property’s operating expenses and mortgage are deducted from all the income coming in from the property. In other words, cash flow is in effect all the income produced by a rental property less all of the expenses required to own the property.
Whenever more money comes in from a property than goes out, the result, of course, means that you have a “positive cash flow” available to pocket and perhaps appropriate elsewhere. Conversely, when it becomes necessary to spend more on the bills than what is collected, you have a “negative cash flow” which means a shortfall that will require you to pull from your pocket; thus wiping out the likelihood of having any cash for you to take off the table.
What is CFBT?
CFBT, or cash flow before tax, can be best understood as the cash flows created from the property throughout a specific time period prior to any adjustment for income taxes. That is, it is the money remaining after the income is collected and the expenses and mortgage payment is made, but it does not take into account the property’s impact on the owner’s tax liability. In other words, it is income that must be declared by the owner to the Feds and as such is subject to taxation by the IRS.
Here’s an example of how to compute it.
Say, for example, that your income-producing property produces an annual rental income (after vacancy allowance) of $58,000, operating expenses of $23,000, and the annual loan payment is $25,000. Your annual cash flow before taxes (CFBT) would be $10,000 (which is still subject to taxation).
What is CFAT?
Cash flow after tax in essence means that the cash flows generated by the income property have been adjusted for taxes and therefore does take into account any tax liability that the owner incurs by reason of operating the property. The computation is straightforward: Cash Flow Before Taxes less Income Tax Liability equals Cash Flow After Taxes.
Before we consider an example, though, let’s look at income tax liability in order to understand its meaning and computation.
Tax liability is what the real estate investor and owner of the property owes in taxes based on the taxable revenue produced by the property. Here’s the calculation: income less operating expenses (i.e., the net operating income) less deductions for depreciation, mortgage interest and loan points compute the taxable income. Then the taxable income is multiplied by the investor’s marginal income tax rate (i.e., combined fed and state) to calculate the investor’s income tax liability.
Okay, now let’s consider an example.
Say that the net operating income generated by the rental property in one particular year is $32,833, furthermore, in that given year that the investor took the following allowable deductions: interest expense of $20,048, amortized mortgage points of $112, and depreciation of $11,710.
1) To begin with, we must first determine the taxable income. We do this by taking the net operating income of $32,833 and subtracting the total deductions taken of $31,870, which in turn results in a taxable income of $963.
2) Secondly, we multiply that taxable income of $963 by the investor’s marginal tax rate in order to calculate the owner’s income tax liability. In this case, we’ll assume that the investor’s marginal tax rate is 38%. Therefore, the resulting taxable income equals $366 (963 x .38).
3) Finally, we subtract that tax liability of $366 from the cash flow before tax (or CFBT) of $8,658 in order to compute the cash flow after tax (or CFAT), which in this case is $8,292. It should be pointed out, though, that if the tax liability was a negative amount it would mean that the investor lost money that year by owning the property and is entitled to a tax deduction. In that case, the loss (which actually constitutes a tax savings) would be added to the cash flow before taxes.
Okay, now compare what the CFBT was to the CFAT so you can understand why this is important to real estate investors doing a rental property analysis. Whereas before taxes, we were seeing a cash flow of $8,658, after the Feds take their cut we see $8,292. Granted, not that significant from our example, but you get the idea. There may be times when there is a significant difference. Therefore you would not want to invest in a rental property without full consideration of what the tax implications might be by owning that property.