Understanding Cash Flow and Taxable Income
In our previous article, we discussed the meaning of Net Operating Income - what it includes, what it does not include, and what significance it has to our understanding the worth of an income property. The topics of Cash Flow and Taxable Income are natural follow-ups to that subject.
Whether we own an office tower on Main Street or a duplex on Elm Street, we approach it with the same basic set of expectations. We intend to collect revenue, mostly in the form of rent, and also to spend money for the various operating expenses, mortgage payments and improvements that, quite literally, come with the territory. At the end of the year, we hope to have taken in more than we paid out, and to keep as much of it as possible away from the tax collector.
When we look back at a year of operating our property, a reasonable question for us to ask is, "How much did I make this year?" The answer lies in an analysis of Cash Flow and Taxable Income.
Recall our earlier discussion of Net Operating Income. NOI is the property's Gross Scheduled Income, less Vacancy and Credit Loss, less Operating Expenses. NOI is a critical part of analyzing any real estate investment, and it is the starting point of our discussion here. Once we know the property's NOI, we branch off in one direction to figure its Taxable Income and in another to figure its Cash Flow. As we'll see later, these two branches eventually reconnect to give us our true bottom line:
Let's look at these two branches and see how they differ.
Taxable Income or Loss
Both branches start with Net Operating Income. Remember that mortgage payments play no part in the NOI calculation, so it is now, below the NOI line, that we will take financing into account.
When we make our Taxable Income calculation, we can deduct only the interest portion of the loan payments. Likewise, if we earn interest (on our escrow account, for example), we must add that back into our income.
We also make deductions for depreciation and amortization. When we purchase a piece of investment real estate, we can't simply deduct its full cost immediately as an investment expense. Instead, we can deduct each year a portion of the value of the depreciable asset, until finally we have written off the entire amount. With real estate, we may treat the physical structures (i.e., the buildings) as the depreciable asset for tax purposes, but not the land.
(An editorial aside: The author, having learned the commercial real estate business in the Pleistocene Age, still uses the traditional term, "depreciation." In the Modern Age of unrelenting political correctness, you will frequently find this same concept referred to as "Cost Recovery." Congress, ever the subtle wit, no doubt became uncomfortable with an economic term that conveyed the notion of unremitting decay and collapse and chose to replace it with one that imparted a sense of a rise-from-the-ashes return to health and well-being. No political agenda here, of course. It is interesting to note that they could not let go of the term "depreciation recapture," which seems to conjure up subliminal images of the taxpayer as escaped convict, once again ensnared.)
At this writing, we may choose to depreciate a residential income property over 27.5 years, and a non-residential property over 39 years. Since not everyone buys or sells on the first of the month, the tax code tries to even matters out with a so-called "half-month convention" which allows the taxpayer to claim only half the normal amount of depreciation in the month that the property is placed in service, and half in the month when it is sold.
Another item that affects our taxable income is amortization. It is important to understand that the term, as used here, does not refer to the principal portion of a loan payment. Instead, it refers to the process of taking a partial annual tax deduction for an item that cannot be expensed in a single year. A good example of a cost that must be amortized is the premium you pay for securing a loan, commonly called "points." We typically pay this premium in one lump sum on the day we close the loan, but we must amortize it over the life of the loan. So, if we take out a 240-month investment-property loan for $720,000 that requires payment of 2 points (2%, or $14,400), we can deduct $60 per month, or $720 for each full tax year.
To review, our Taxable Income is our Net Operating Income less interest payments, plus interest earned, and less our allowable write-offs for depreciation and amortization.
Cash Flow Before Taxes
Cash Flow is even simpler. Think of it as our property's checkbook. It is everything that came in, less everything that went out. By starting with Net Operating Income, we have already accounted for all of the rent revenue, credit losses and operating expenses. Where else do we spend money?
We make mortgage payments, and now we can count the entire payment. We may also make capital improvements to a property. An improvement prolongs the life of a property. It is different from a repair, which maintains, rather than increases, that life expectancy. The cost of the improvement affects our cash flow as soon as we spend the money, even though we may typically have to write it off over 27.5 or 39 years.
Our lender may require us to fund a reserve account, so that money will be available in the future to make repairs or improvements. Transferring money from the property's checkbook to this reserve account reduces the property's cash flow. If we fund that account on day one of our investment, we might treat that amount as part of our initial cash investment; but if we make future periodic contributions to the reserve fund, they must come out of the property's cash flow.
The short version of our discussion now boils down to this: To derive our property's Taxable Income, we take its NOI and subtract everything that is properly tax-deductible. To derive its Cash Flow, we take its NOI and subtract everything that was actually disbursed but not already accounted for in the NOI computation itself.
Cash Flow and Taxable Income are closely related, but still have important differences (not unlike a good person and his or her evil twin). Cash Flow is real. Money comes in, money goes out. You earnestly hope the difference will always be a positive number, and if it is, you can take it with you and even spend it. With all due respect to the considerable industry that is built around tax planning and preparation, Taxable Income is not quite so real. It is whatever the tax code du jour says it is. If tomorrow the House of Representatives should decide that the useful life of commercial real estate ought to be 100 years instead of 39, then our property's taxable income will rise without generating a single additional dollar in rental income. Why? Because the longer write-off period would mean smaller annual deductions for depreciation, and fewer deductions mean higher taxable income - despite the fact that our gross and net incomes are unchanged. Likewise, if mortgage interest were no longer deductible, the effect of the mortgage payment on our cash flow would be unchanged, but the effect of the lost deduction would be to increase our taxable income.
Cash Flow After Taxes
This talk of deductions brings us to the fulfillment of an earlier promise, to reconnect the two branches of our diagram. Up until now we have been speaking about Cash Flow Before Taxes (CFBT), but the true bottom line to us as investors is Cash Flow After Taxes (CFAT).
While Taxable Income may be a somewhat arbitrary notion, the tax liability it provokes is very real indeed. Taxable Income creates one last cash flow item: income tax, which must be subtracted from our Cash Flow Before Taxes to give us our real bottom line, Cash Flow After Taxes.
Keep in mind that our Taxable Income may be negative as well as positive. If it is, then it may actually result in a negative tax liability and increase our Cash Flow After Taxes by sheltering other earnings. (There are limitations on the use of such losses, a topic that merits its own article.)
A Case Study
An example may be the best way to understand how all of these numbers work. The following was produced with the cash flow section of the new "Lite" version of RealData®'s Real Estate Investment Analysis 10.0. For simplicity, we will show just the first five years of what is actually a 10-year pro forma projection of the Taxable Income and Cash Flows of a property. In this analysis, the property is acquired in March of 1998 for $1,200,000. It has a depreciable basis of $908,000. The program has adjusted the income, expenses, debt service, depreciation and amortization to account for the partial first year. We start with a derivation of the Net Operating Income.
In 1998 our Gross Scheduled Income is $173,500. From that we subtract a 3% allowance for vacancy and credit loss, and $34,065 in operating expenses. That leaves us with a first year NOI of $134,230. (Note: These amounts have been carried forward from an earlier, income-and-expense module in the program. Likewise, the figures shown below have all been calculated by the software.)
From the NOI, we follow the first branch, which calculates the Taxable Income:
Note that we are subtracting out the interest paid on each of the three mortgages, because that interest is deductible.
You will recall that we said the depreciable basis of this property is $908,000. It is an office building, so we depreciate it over 39 years. 908,000 divided by 39 is 23,282, which is what we find in years 1999 and after. But what about 1998? Remember that we acquired the property in March, and that the "half-month convention" allows us to take only one-half the normal depreciation for the month that we place the property in service. In 1998, therefore, we are entitled to 9 ½ months of depreciation. One month of depreciation would be the yearly amount divided by 12 (23,282 / 12), or 1,940.17. Multiply this by 9.5 months, and we get our 1998 depreciation as shown, 18,432.
We will make a $10,000 capital addition to the property in the fifth year (2002), and so we depreciate that as well from the time it is placed in service. We use the same 39-year useful life for this improvement. Therefore a full year of depreciation is 10,000 divided by 39, or 256.41. Since we must use the half-month convention in the first year, we can take only 11.5 months of depreciation, which is 246 when rounded to the nearest dollar. (Note: You may occasionally see 2 plus 2 equal 5 in our illustrations. Don't be alarmed. This is caused by rounding.)
We paid two points on the $720,000 first mortgage for a total of 14,400 (720,000 x 0.02). It is a 20-year note, so we divide the total amount of the points by 240 to find that we can deduct $60 each month. We deduct $600 for the 10 months of 1998 and $720 per year thereafter until we have written off the full amount. The points for the second mortgage, of course, work exactly the same way.
We project that the property will put $5,000 of its cash into a reserve account in the second year, earning 3% interest on that money annually. We earn no interest in the first year, but from 1999 on we will add the interest to our taxable income. We also subtract each of the deductible items from our Net Operating Income to give us a projected Taxable Income for each year.
Now let's look at the Cash Flow branch:
Again we start with the NOI. From that amount we subtract the full amount of all mortgage payments (not just the interest). We will take money out of the property in 1999 to put into our reserve account, and it must be subtracted from our cash flow. Note that interest earned on our reserves stays in the reserve account; it does not add to our cash flow. We will make a capital addition to the property in 2002, and that too will impact our cash flow in that year.
In this example, we have the same NOI as before, of course, and our disbursements in 1998 are the payments we make on three mortgages. We subtract those mortgage payments from the NOI to leave us a positive Cash Flow Before Taxes in 1998 of $57,200. In 1999 we must also subtract the funded reserves, and in 2002 the capital addition.
To get to our bottom line, we need to estimate our income tax liability so that we can figure our Cash Flow After Taxes. The calculation of the projected income tax liability can be fairly complex, involving passive loss limitations and suspended losses carried forward (that's why we have computer software), but we've chosen this particular sample analysis because of its simplicity. As in our chart above, we have to go back to the Taxable Income calculation to retrieve the 1998 Taxable Income of 51,971. From that we calculate the income tax liability that is attributable to our ownership of the property (the Taxable Income of 51,971 times the investor's marginal tax bracket of 31%).
In short, we have a 1998 Cash Flow Before Taxes of $57,200 and a tax liability of $16,111, leaving a Cash Flow After Taxes of $41,089.
Note that our CFAT drops just a bit in 1999, our first full year of operation, after being drained $5,000 for reserves. In the year 2000 we have no payment to reserves and we also enjoy a modest increase in rental income. These combine to overcome an increase in debt service on the first mortgage due to an anticipated rate increase. The fourth year is uneventful, and we have a small increase in cash flow. In the fifth year we have another drop due to our $10,000 capital expenditure. All in all, our Cash Flow After Taxes seems to waffle around the $40,000 level. An investor who hasn't seen a positive number in this row since the Tax Reform Act of 1986 might just tell us to shut up and count our blessings.
Without a positive cash flow, our property becomes like the plant in Little Shop of Horrors, greeting us with a baritone "Feed me" at every turn. A positive cash flow is important to all of us and essential to some. Is Cash Flow After Taxes, then, the end of our continuing saga of investment analysis? Not at all. In upcoming articles, we'll look at the ultimate resale of our property, and at different ways to measure the overall quality of an investment.