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 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 to know the cash flow after tax (CFAT), there are some who simply want to the determine the income that a property will generate before taxes (i.e., CFBT). Fair enough. So what’s the difference?
What is Cash Flow?
This is that flow of funds that result from money coming in and money going out. In other words, all the income generated by the investment property less all of the expenses to hold the property creates the cashflow. When you take in more money then you spend (i.e., money is leftover after all the bills are paid) the cashflow is positive, and therefore available for you to take off the table and allocate elsewhere.
On the other hand, if you spend more than you take in it results in a negative cashflow that requires you to pull money from your own pocket (i.e., outside the property account) to make up the deficiency, therefore creating a vacuum you must fill without any hope of residential cash.
What is CFBT?
CFBT is an acronym for cash flow before tax and essentially signifies that any cash flows produced by the rental property during a given period of time are computed prior to any adjustment for taxes and therefore does not take into account the property’s impact on the owner’s income tax liability. For example, if a rental property generates an annual income stream (i.e., rental income less vacancy allowance) of $54,720 with annual operating expenses of $21,888 along with an annual mortgage payment of $24,174, the annual cash flow (before taxes) would be $8,658.
What is CFAT?
CFAT is an acronym for cash flow after tax and essentially signifies that any cash flows produced by the rental property are computed after adjusting for taxes and as such does account for any tax liability that the owner encounters as a result of operating the property. The calculation is straightforward: Cash Flow Before Taxes less Income Tax Liability equals Cash Flow After Taxes.
Before we look at an example let’s consider what income tax liability is and how it gets computed.
Tax liability is what a real estate investor owes in taxes based on the “taxable income” generated by the property. Income less operating expenses (i.e., the net operating income) less deductions for depreciation, mortgage interest and loan points compute the taxable income which is then multiplied by the investor’s marginal income tax rate (i.e., fed and state) to compute the investor’s income tax liability.
Okay, now let’s consider an example.
Say the net operating income is $32,832 along with an annual interest expense of $20,048, amortized loan points of $112, and a depreciation (or cost recovery) allowance of $11,710.
First, we compute the taxable income by subtracting those amounts from the net operating income (the result being $963). Secondly, we multiply that taxable income of $963 by the investor’s marginal tax rate (say 38%) to compute the owner’s income tax liability (the result being $366). Finally, we subtract that tax liability of $366 from the cash flow before tax of $8,658 we computed earlier in order to determine the cash flow after tax (the result being $8,292).
All of this is computed automatically by my real estate investment software and posted in the Proforma Income Statement (which is also created automatically). You can see a sample on my website at http://www.proapod.com by clicking Executive 10.0 then Reports then Proforma Income Statement.
Here’s to your real estate investing success.