GUEST POST: Carter Froelich, CPA http://www.thepropertyledger.com/
In our series of articles to date we have focused on the elements which are included in the calculation of net operating income (“NOI”) and why NOI is so important in the determination of operational performance and value of a rental property. However, NOI is not the end point of your journey to determine the response to the question “how much money did my property make this year?” To answer this question you have to determine the property’s taxable income.
Taxable income a rental property’s NOI less that certain costs which are allowed as additional deductions for federal tax purposes. The additional expenses on your real estate investment property which are deducted from NOI to arrive at taxable income are interest on mortgage indebtedness, depreciation and amortization.
Interest on Mortgage Debt - If you have utilized a mortgage in the purchase your property, be it a first, second or third mortgage the federal government allows you to deduct from NOI that portion of the mortgage or mortgages which related to interest payments. For instance, if you took out a $120,000 mortgage to purchase a property and paid a 6.5% interest rate amortized over 30 years, you have made payment equal to $9,189 of which $7,800 of these payments would have represented interest on the mortgage. When calculating taxable income this amount ($7,800) may be deducted from a property’s NOI.
Depreciation - In order to allocate a rental property’s costs over its useful life the federal tax code allows you to deduct a portion of the rental property’s cost each year from NOI to determine taxable income. After making an allowance for land costs as land costs are not depreciable, the resulting amount is your deductable basis for tax purposes. Generally land costs are assumed to be approximately 20% of a residential home’s purchase price but this amount may vary by location so please consult with an appraiser in your area to determine the land value on your real estate investment property. The tax code allows residential property to be depreciated over 27.5 years while commercial property is depreciated over a 39 year period. As such, assuming that we purchase a $150,000 single family rental property the annual depreciation allowance which would deduct from NOI is calculated as follows:
The important thing to remember is that this $4,364 deduction is not costing you any money. It is merely an accounting provisions which allows you to deduct a portion of our property’s costs against the income generated in that particular year. In a nutshell, the depreciation deduction allows you to not have to pay taxes on $4,364 of net rental income produced by the property. Remember also that if your are making capital improvements to your property which prolong the life of the property such as adding a new roof, these costs must be accounted for and depreciated over their useful life. Make sure consult with your tax advisor in relation to this matters.
Amortization –Amortization is similar to that of depreciation however rather than applying to a physical asset such as a rental property, it applies to “soft costs” which pursuant to federal tax code you are not able to expense in one year. A good example of a cost which is required to be amortized is that of loan origination fees which are required to be spread over the life of the loan. Thus if you paid $2,500 in order to secure your financing for the 30 year mortgage, $83.33 per year may be deducted from the property’s NOI to recognize this cost.
If you using The Property Ledger™ to perform your investment analysis you are aware that these calculations are performed automatically for you.
Investment Property Cash Flow Before Tax
Cash flow from a rental property is much easier to calculate for a rental property than taxable income. In fact, if you use a checkbook to pay for you rental property you already understand the concept of cash flow. Cash flow is merely the difference between what you take in and what you pay out.
Again we start with NOI as our starting point and deduct debt service along with capital expenditures which were made in the current year.
Cash flow and taxable income are similar in some ways but they are different, cash flow for instance is real, it is the money you have left in your checking account after all of the bills have been paid and capital expenditures made to the property. Taxable income on the other had while it begins with NOI has many “phantom” adjustments which must be made to NOI and do not reflect the actual expenditure of funds for the year on your real estate investment property. Taxable income is an accounting function, not reality.
The relationship between taxable income and before tax cash flow is illustrated below:
Cash Flow After Tax
Cash flow after tax requires the combining of the two concepts shown above. The first step in the determination of after tax cash flow is to calculate the tax which is due by multiplying taxable income by your tax rate. To the extent that one has positive taxable income a tax payment will be required. The extent that one has a negative taxable income, a tax savings will be created. Once the tax has been determined, this amount is either subtracted (tax payment) or added (tax savings) to the before tax cash flow to determine the after tax cash flow. While this discussion of taxes related to rental property is overly simplistic, this should give you an understanding of the basic concept of after tax cash flow. As always, I strongly recommend that you speak with your tax consultant in relation to matters surrounding tax planning.
Now that we have discussed the basics of cash flow analysis, in our next issues we will look at investment return metrics.
Carter Froelich, CPA is the founder of The Property Ledger™ a web based real estate investment software. To get a free 30 day trial of The Property Ledger™ see our web site.