Real estate investing can be an excellent way to create an additional source of income. But when you’re just getting started, it can be difficult to learn all the jargon. Additionally, it’s easy to feel overwhelmed by all of the different calculations and analyses that are seemingly important. One of the calculations you’ll want to learn when you start investing in real estate is the after-tax cash flow, which is the cash flow that’s left after debt service, operating expenses, and taxes. In most years, you would hope to see an after-tax cash flow that’s positive, but it’s not unusual for it to be negative in a year where you’ve made large investments into the property.
The most important first step in calculating after-tax cash flow is to determine your net income for the year. According to the IRS, rental income is “any payment you receive for the use or occupation of property.” Rental income can include any of the following:
Once you’ve calculated your gross rental income, you can find the net income by subtracting your operating expenses. These can include maintenance, insurance, administrative expenses, debt service, and any other expenses you incur. However, you shouldn’t include tax expenses or deductions here. Once you’ve determined your net income, you can figure out how much tax you’ll owe on that income. The good news is that in addition to reporting your rental income, you’ll be able to report and deduct your real estate expenses and depreciation. According to the IRS, you can deduct “the ordinary and necessary expenses for managing, conserving and maintaining your rental property.” Examples of ordinary and necessary expenses include:
For the purpose of federal taxes, you’ll report your rental income and expenses on Form 1040, Schedule E. Part I of that form is dedicated to rental real estate and royalties. You’ll have to report the following information:
Your net rental income is taxed at your ordinary federal income tax rate, which ranges from 10% to 37%. It’s possible that your expenses will exceed your income—meaning you won’t owe taxes—but your losses will be limited by the passive activity loss rules and at-risk rules. Keep in mind that depending on where you live, you may also be on the hook for state income taxes. How much you’ll owe and how you’ll report that income depends on where you live and the state where the property is located. Once you’ve determined your net rental income and taxes owed, you can easily calculate your after-tax cash flow. The formula will look like this: After-Tax Cash Flow = Operating Income - Operating Expenses - Debt Service - Taxes Owed A simplified version of the formula would be: After-Tax Cash Flow = Net Income - Taxes Owed Knowing how to calculate your after-tax cash flow is an important part of real estate investing. This calculation gives you the most accurate view of your real estate income. While looking at your gross income—or even your net income—might give you some idea, they aren’t fully accurate unless they include all of your expenses and taxes.
After-tax cash flow helps you get a better financial picture of your investment. You can calculate your after-tax cash flow by subtracting your operating expenses, debt service, and taxes from your gross operating income.
Rental income is taxed as ordinary income, meaning it will be taxed at the same rate as the rest of your income and could possibly push you into a higher marginal tax bracket. However, you can offset some of that by taking deductions on certain ordinary and necessary expenses related to that rental property.
In real estate, your cash flow before taxes is your operating and expenses subtracted from your debt service. It’s similar to calculating your after-tax cash flow but without taking into account any taxes you’ll owe.
Operating and Capital Costs deducted from Revenue gives the Before-Tax Cash Flow. And After-Tax Cash Flow equals Before-Tax Cash Flow minus Income Tax. Example 7-1:Assume a project that has the estimated gross revenue of $28,000 dollars, operating cost of $12,000, and capital cost of $10,000 next year with the income tax of $1,500. Then, next year After-Tax Cash flow can be calculated as: After-Tax Cash flow=$28,000−$12,000−$10,000−$1,500=$4,500From a tax view point, there are two types of investments. According to US tax law, for the purpose of tax calculations, an investor is allowed to recover some specified types of investments, meaning that the investor can take some amounts of money from the generated revenue as tax deductions. Types of property that may be recovered over their useful lifetime are including (but not limited to) building, machinery, equipment, and trucks. Simply, most of the property types that lose their value over the time (have zero or low salvage value) may be allowed to be recovered. On the other side, there are investments that can’t be deducted from income for tax purposes. Investing in a bank account or buying land are the examples of this type. Example 7-2:Assume an investor deposits $100,000 in a bank account for 10 years with annual interest of 16% and will take the $100,000 in the end of 10th year. Calculate Before-Tax Cash Flow and After-Tax Cash Flow in this investment considering the income tax of 25%. The annual income will be $100,000*0.16=$16,000 . Since tax deduction is not allowed for investments such as bank account and bond, the annual revenue is fully taxable. Income tax per year=$16,000*0.25=$4,000.
In order to determine After-Tax Cash Flow, we need to determine the taxable income and deduct the tax from Before-Tax Cash Flow.
By trial and error, the ROR=12% is calculated for this After-Tax Cash Flow. Example 7-3:Now, assume the investor pays 100,000 dollars for a machine at time zero, and the machine can start producing goods and generating annual revenue of $38,000 with operating cost of $12,000 from first to 10th year, and the salvage value will be zero with income tax of 25%. The Before-Tax Cash Flow here can be determined as:
By trial and error, ROR=22.6% for Before-Tax Cash Flow. In this hypothetical case, the investor is allowed by tax law to recover the out of pocket cash “capital cost” and gradually deduct it from taxable income. One way to calculate the taxable income for each year is to distribute the capital cost of $100,000 equally over the allowable depreciation life time of 10 years. And After-Tax Cash Flow will be determined as:
This way, the taxable income for each year would be 16,000 dollars, which gives the tax of 16,000*0.25=4,000 dollars . Note that, in reality, no annual cash is transferred and the annual sum of $10,000 (non-cash capital cost deduction) is applied just for the purpose of tax calculations. This annual sum is called non-cash capital cost to adjust and recover the the capital cost of $100,000 at time zero. And when tax is calculated, $10,000 has to be returned to cash flow to give the After-Tax Cash Flow. ROR for After-Tax Cash Flow is 17.7%. Applying tax deductions to recover the investment causes lower taxable incomes and consequently lower taxes and can only be used for specified types of properties. Investments that are allowed to be recovered by tax law are divided into two categories. 1)Investments that can be expensed: These investments are allowed to be deducted from revenue in full amount in the year of occurrence for tax calculation. 2) Capital costs: These investments are allowed to be deducted gradually (cost needs to be distributed over more than one year) from the revenue for tax calculation. Acquisition costs and lease bonus costs paid for mineral rights for natural resources such as oil and gas are examples of investment property costs that may be recovered by depletion. Numerous other business costs such as the cost of acquiring a business lease, research and development costs such as expenses, trademark expenses, and pollution control equipment costs may be recovered by amortization. Depreciation, depletion, and amortization all achieve essentially the same thing—recovery of the cost or other basis of investments in before-tax dollars through allowable tax deductions over a specified period of time or over the useful life of the investment. If depreciable property is sold, all or a portion of any extra depreciation claimed in prior years may have to be recaptured as taxable income. These methods will be explained in this lesson. Please watch the following video (4:34): After Tax Cash Flow.
After Tax Cash Flow Click for the transcript of "After Tax Cash Flow" video.
PRESENTER: In this video and following videos, I will explain how to calculate tax deductions and after tax cash flow. Tax law allows the investors to recover some unspecified types of their investment through tax deductions, meaning that the investor can take some amount of money from generated revenue as tax deductions. Types of property that may be covered over their useful life are including but not limited to building, machinery, equipment, and trucks. If the property doesn't lose its value, it cannot be recovered through tax deductions. A good example of that is bank accounts or land. If you buy land, it is assumed that the land value is not going to be lower after a couple of years. So you're not allowed to recover the amount of money that you paid for the land through tax deductions. So there are two main categories of investments that can be-- that are allowed to be recovered through tax deductions. The first category is called investments that can be expensed. Expensed means they can be recovered in full amount in the year that they happen. An investor can deduct that expense, that investment, in full amount, from the revenue in the year that investment has occurred. The other type of investments are the ones that can be capitalized. Capitalized means they can be deducted over more than one year as tax deductions. So the difference between investments that can be expensed from the investments that can be capitalized is just the time. Here, we can see business costs that can be expensed. They can be deducted in full amount in the year that they happen-- operating costs, research and experimental costs, mining, exploration costs, mining development costs, petroleum intangible drilling costs, or IDC. Depreciation, depletion, and amortization are methods to capitalize the business costs. And essentially, they do the same thing. But they are applicable to different categories of costs-- for example, acquisition costs and lease bonus costs or paid for mineral rights or natural resources. They can be recovered by depletion, and costs such as acquiring a business lease or trademark expenses, they can be recovered by amortization. So it is obvious that the faster investors recover their expenses, it's better for them. It is going to have positive economic effect on the project. For example, if there is no limitation in recovering the investments, investors would prefer to recover all their costs, all the investment, in full amount in the year that they are paying that because the earlier you get your money back, it has higher value than when you get it in a later future. In general, After-Tax Cash Flow requires the following calculations: Revenue - Operating Costs - Depreciation - Depletion - Amortization - Write-offs ———————————————— Taxable Income - Income Tax ———————————————— Net Income + Depreciation + Depletion + Amortization + Write-offs - Capital Expenditures ———————————————— After-Tax Cash Flow (ATCF) Where, Depreciation, Depletion, Amortization, and Write-offs are called Non-cash capital cost deductions. ATCF can be written in form of equation as: After-Tax Cash Flow=Net Income+Non-Cash deductions–Capital cost Or After-Tax Cash Flow=Sale Revenue–Operating Costs–Income Taxes–Capital Costs As explained in Example 7-2 and 7-3, depending on the characteristics of investment, Before-Tax Cash Flow and After-Tax Cash Flow calculations might be different and may give different economic results. Italicized sections are from Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14th edition. Lakewood, Colorado: Investment Evaluations Co. |
What is the after tax cash flow from the sale at the end of year 3?
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