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Understanding Real Estate Investment Cash Flows
The objective behind any real estate investment is the cash flow produced by the property. Ask any rental property owner: “Cash is king” when it comes to investment decisions for both profitability and returns.
So this article felt it necessary to discuss how cash flow is derived from an asset, and why investors can only expect to pocket some of it permanently after the Feds tax it. Hope that helps those of you who are new to real estate investing.
We’ll start with a simple definition: cash flow is the total revenue stream of a rental property. In other words, it’s cash after all rents are collected and all expenses necessary to service and own the property (ie, operating expenses and debt service) are paid.
OK, but it should be understood that there are two types of real estate cash flow typically generated by rental income properties. For our purposes we will categorize them as “ongoing” and “one-time” to make a clear distinction that makes it easier to explain and understand.
Current cash flow is money received during the holding period due to renting space. In other words, the money earned from the day-to-day operations of the rental property. You can get an idea if you consider all the cash flows like rent, loan balances and interest on bank accounts, less money like operating expenses, debt servicing and capital additions.
This is an “income stream” that is generated by the rent during the investor’s ownership of the property. It can be known as daily, weekly, monthly, yearly or any flow. It can also result in an amount that is positive or negative (ie, there is money left for the investor, or nothing left for the owner to supplement out of pocket).
at a time
This is the cash flow that results from the sale (or reversal) of an asset. In other words, this amount represents the “one-time” cash revenue collected when the investor transfers title to the buyer and is no longer the owner.
This is a one-time sale, and the resulting amount can be positive (worthy of some congratulatory back-slapping) or negative (probably not).
OK, but this is just the beginning. As mentioned earlier, both types of cash flows produced by investment real estate are subject to income taxes. So let’s step into it and see how it all comes together.
Current income streams are subject to annual income taxes. So in this case, we will think in one of these two ways. However, remember that we are talking about taxes payable “annually” and therefore each formulation below reflects the “annual” amount.
First, we have cash flow before tax (or CFBT). It reflects the money collected by the owner before the tax liability. This money is therefore subject to the investor’s annual federal income taxes. The formula here is very simple: net operating income less debt service.
Net operating income
– Debt servicing
Secondly, we have cash flow after tax (or CFAT). This provides the amount available to the investor after the IRS is satisfied. This is especially important for real estate investors because it represents the amount of spendable cash generated by the rental investment after deductions for taxes.
Achieving this figure is slightly more complicated than CFBT and requires several steps. Naturally, the financial data of the property and the owner’s tax rate must be determined in advance.
Net operating income
– Interest paid on loan
– Depreciation Allowance
– Amortized borrowing costs
= taxable income
x Investor’s tax rate
= Income Tax Liability
Cash flow before taxes
– Income tax liability
= after-tax cash flow
Okay, now let’s turn to the lump sum money an investor can collect upon selling their rental property investment.
In this case, we should consider the sales amount before and after income tax. Same idea as before. The proceeds from the sale are subject to taxation. So there is the pre-tax money that the investor can collect from escrow at the end of the sale, and then the after-tax proceeds that the investor can actually pocket after the taxes are paid. Here is the formulation in three steps.
– Cost of sales
– Loan repayment
= Sales process before tax
Federal sales tax
– Allowable deductions on sales
= Tax due to sales
Sales process before tax
– Tax due to sales
= Sales amount after tax
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