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Understanding Real Estate Investment Cash Flows
The goal of any real estate investment is the cash flows generated by the property. Ask any rental income property owner, “Cash is king” when it comes to making investment decisions for profit and rate of return.
That’s why this article felt it necessary to discuss how cash flow originates in real estate, along with why investors can expect to pocket only a portion of it permanently after the feds take a bite out of the taxes. Hope it helps those of you who are new to real estate investing.
We’ll start with a simple definition: cash flow is all income inflows of a rental property, minus all outflows. In other words, it is the money left over after all rents have been collected and all costs necessary to service and own the property (ie operating costs and debt service) have been paid.
Okay, but it’s important to understand that there are basically two types of real estate cash flow that is typically generated by rental income. For our purposes, we will categorize them as “permanent” and “disposable” to draw a clear distinction that facilitates interpretation and understanding.
Current cash flows are money received during the holding period as a result of renting space. In other words, it’s the money that comes from the day-to-day running of the rental property. If you think of it as all the money coming in, like rent, loan proceeds and interest on bank accounts, less all the money going out, like operating expenses, debt payments, and capital gains, you’ll get the idea.
This is the “income stream” generated by the rental while the investor owns the property. It can be treated as daily, weekly, monthly, yearly or any stream. It can also result in an amount that is positive or negative (ie, the investor is left with money or nothing, which the owner must add out of pocket).
This is the cash flow that arises from the sale (or disposal) of an asset. In other words, this amount represents the “one-time” cash income that the investor collects when he transfers ownership to the buyer and is no longer the owner.
This is a one-time sale proceeds and can also result in an amount that is either positive (may lead to a few pats on the back) or negative (maybe nothing).
Okay, but that’s just the beginning. As mentioned earlier, both types of cash flows generated by investment properties are subject to capital gains tax. So let’s step into it and see how it all comes together.
Current streams of income are subject to annual income tax. So in this case they would be treated in one of two ways. However, remember that we are talking about “annual” taxes, so each of the formulations below reflect “annual” amounts.
First, we have cash flow before taxes (or CFBT). This reflects the money the owner collects before tax liability. Therefore, it is money that is subject to the investor’s annual federal income tax. The formulation is fairly simple: net operating profit minus debt service.
Net operating profit
– Debt service
Second, we have cash flow after taxes (or CFAT). This provides the amount of money available to the investor after the IRS is satisfied. This is usually more important to a real estate investor because it represents the amount of cash generated from the rental investment after taxes.
Arriving at this number is a bit more complicated than CFBT and requires more steps. Of course, the financial data of the property and the tax rate of the owner must be determined in advance.
Net operating profit
– Interest paid on the loan
– Value correction
– Loan repayment costs
= Taxable income
x Tax rate of the investor
= Liability for income tax
Cash flow before taxes
– Income tax liability
= Cash flow after taxes
Okay, now let’s move on to the money an investor could collect once they sell their rental property investment.
In this case, we must consider the proceeds from the sale before and after income tax. This is the same idea as before. The proceeds from the sale are subject to taxation. Therefore, there are pre-tax proceeds that the investor can collect from the escrow at the close of the sale, and then there are after-tax proceeds that the investor can actually pocket once the taxes are paid. Here is the formulation in three steps.
– Cost of sales
– Loan repayment
= Sales proceeds before tax
Federal sales tax
– Allowed sales deductions
= Taxes due to sales
Profit from sale before tax
– Sales taxes
= Sales proceeds after tax
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