Real estate investors are generally looking for tax write-offs, long-term appreciation, or cash flow— and if you twist their arms, they’ll take all three. If they had to choose just one, well—as they say—cash is king. The advantage of positive cash flow (more money coming in than going out) is that the property is self-sustaining, and the investor can take the profits and reinvest in another property.
Investors like to know everything there is to know about their cash. They want to know their cash flow, their before-tax cash flow, their after-tax cash flow, and how to shelter their cash from taxes.
Before-Tax Cash Flow
The before-tax cash flow is calculated before income taxes are figured into the equation. So if an investment property is generating $20,000 in income, and expenses are $12,000, that’s a net return (cash flow) of $8,000.
Investors also like to know their cash-on-cash-return. Cash-on-cash return is the ratio of annual before-tax cash flow to the amount of cash they’ve invested, and it’s expressed as a percentage.
So if our investor had an annual before-tax cash flow of $9,000, and had put $350,000 down on the property, the cash on cash return would be 2.6%.
$9,000 ÷ $350,000 = 0.0257 (or 2.6%)
Note that this is cash invested, which has nothing to do with mortgage debt taken on. So it doesn’t matter if the investor paid $400,000 for the property or $1 million; the cash-on-cash return would be the same. The purpose of this formula is to give the investor an idea of how hard invested cash is working on the investor’s behalf.
Cash-on-cash return is all well and good—but what about those taxes? A 10% cash-on-cash return may sound great, but it can be whittled to nothing depending on the investor’s tax situation. Cash-on-cash also doesn’t account for appreciation of the property, or depreciation of the property. And because the percentage it yields is simple, it may not compare favorably to other investments with perhaps lower risk, and compound interest.
After-Tax Cash Flow
Computing after-tax cash flow solves some of these issues. To determine after-tax cash flow, you simply take the profit yielded from the investment and subtract income taxes that apply to the property’s income.
What if, in doing so, you come up with a negative number? This means the investment is a losing investment in that year; the investor is putting in more money than is being returned by the investment. This paper loss can be used as a tax shelter, and is actually desirable by some investors for that purpose, because shelters can be used to offset other income.
Remember that depreciating an appreciating asset can be a wonderful thing! This paper loss is due in part or whole to the depreciation taken against the investment property. As such it may not “feel” like a loss in terms of cash flow or other purposes, and in fact can be used to reduce tax burden in other areas.