How To Compute Cash Flow Before Tax And Cash Flow After Tax Before Your Next Real Estate Analysis

Real estate investors and real estate investing experts generally aim to be aware of cash flow after tax (CFAT) when looking for the profitability of investment property during a real estate analysis since it includes the elements of tax shelter and shows the money an investor might receive from the property after the Government takes a bite out of it.

Nevertheless, despite the recognition among real estate investors and many experts to understand the cash flow after tax (CFAT) generated by a property, you will find some who just determine the cash flow a property will generate before taxes. Fair enough. So exactly what is the difference between these two cash flows?

Understanding Cash Flow

Cash flow is that flow of funds that result from money coming in and money going out. In other words, cash flow is in effect all the income produced by a rental property less all of the expenses required to own the property.

Whenever more money comes in from a property than goes out, the result, of course, means that you have a "positive cash flow" available to pocket and perhaps appropriate elsewhere. Conversely, when it becomes necessary to spend more on the bills than what is collected, you have a "negative cash flow" which means a shortfall that will require you to pull from your pocket; thus wiping out the likelihood of having any cash for you to take off the table.

What is CFBT?

CFBT is an acronym for cash flow before tax and essentially means the cash generated by the property during any specific period that does not account for the impact that property ownership has upon the owner's tax liability. In other words, though CFBT is an income that remains after payment for operating expenses and loans, it will have to be declared as "income" by the owner to the IRS and therefore is subject to taxation.

This is how it's computed.

If a rental property produces a yearly gross operating income (i.e., rental income less vacancy allowance) of $54,720, with annual operating expenses of $21,888 and an annual mortgage payment of $24,174, then the annual cash flow before taxes (still subject to taxation) would be $8,658.

What is CFAT?

Cash flow after tax essentially signifies that the cash flows generated by the income property have been adjusted with regard to taxes and as such does take into account any tax liability that the owner encounters by reason of operating the property. The computation 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 the real estate investor and owner of the property owes in taxes based on the taxable revenue produced by the property. Here's the calculation: income less operating expenses (i.e., the net operating income) less deductions for depreciation, mortgage interest and loan points compute the taxable income. Then the taxable income is multiplied by the investor's marginal income tax rate (i.e., combined fed and state) to calculate the investor's income tax liability.

Okay, let's consider the following example.

Let's assume that the property in question has a net operating income of $32,833, that the allowable deduction for depreciation taken that year totals $11,710, and based upon the current financing that deductions were taken that year for interest expense totaling $20,048 and amortized loan points totaling $112.

1) First, we compute the taxable income by subtracting those deductible amounts totaling $31,870 from the net operating income of $32,833. This results in a taxable income of $963.

2) Next, we multiply that taxable income of $963 by the investor's marginal tax rate in order to calculate the owner's income tax liability. In this case, we'll assume that the investor's marginal tax rate is 38%. Therefore, the resulting taxable income equals $366 (963 x .38).

3) Finally, we subtract that tax liability of $366 from the cash flow before tax (or CFBT) of $8,658 in order to compute the cash flow after tax (or CFAT), which in this case is $8,292. It should be pointed out, though, that if the tax liability was a negative amount it would mean that the investor lost money that year by owning the property and is entitled to a tax write off. Therefore that loss (which equates to a tax savings) would be added to the cash flow before taxes.

Okay, now compare what the CFBT was to the CFAT so you can understand why this is important to real estate investors doing a rental property analysis. Whereas before taxes, we were seeing a cash flow of $8,658, after the Feds take their cut we see $8,292. Granted, not that significant from our example, but you get the idea. There may be times when there is a significant difference. Therefore you would not want to invest in a rental property without full consideration of what the tax implications might be by owning that property.