# How to Compute Taxable Income or Loss to Arrive at Cash Flow After Taxes

The profitability of a rental income property, of course, is measured by the amount of cash flow the property generates. What a real estate investor always wants to know when considering his or her profitability from the property for any given year is "How much did I make?" And this is resolved by considering the property's cash flow plus or minus the investor's taxable income or loss.

To compute taxable income or loss we must first determine the property's net operating income (NOI). Net operating income is gross operating income less operating expenses. For example, say a rental property generates an annual rental income of $205,993 and annual operating expenses of $41,718 in: The NOI would be $164,275.

From that amount we then would deduct the annual amounts for loan interest paid, depreciation and amortization, and then add in any interest earned to compute the taxable income or loss.

Okay, let's break it down and then show the formula. It will be more meaningful that way.

**Interest Paid**

The annual amount of interest paid on your loan during any given year is straightforward. Say, for instance, that you made mortgage payments totaling $88,470 of which $23,552 was applied to principal: The amount of interest paid during that year was $64,918.

**Depreciation**

Depreciation is more complex because it depends on the type of real estate being depreciated and what percent is allocated to improvements (land cannot be depreciated).

Depreciation (or "cost recovery") is defined by the tax code as a "loss in value to a property over time as the property is being used" and owners are allowed by the tax code to take a tax deduction each year until the entire asset is written off. The amount of depreciation deduction depends on the income property's "useful life" which the current tax code says is 27.5 years for residential property and 39 years for commercial (nonresidential property) real estate.

For our example we'll keep it simple and just say that the amount of allowable depreciation taken for our income property during this given year was $23,076.

**Amortization**

This refers to the process of taking a partial annual tax deduction for an item you are not allowed to expense in a single year and must amortize, such as "loan points." Though you pay this premium in a lump sum the minute you close the loan you are required to amortize it over the life of the loan.

Again (for simplicity sake) let's just assume that the amortized points allowable by the tax code for our given year were $920.

**Interest Earned**

This concerns the interest income you might have earned on your income property or maybe on an escrow account that your lender required for real estate taxes and insurance.

In this case we'll simply assume that the interest earned is zero.

**The Formula**

Fair enough. Now that you have some idea of what these components represent let's look at the formula.

Net Operating Income less Interest Paid less Depreciation less Amortization plus Interest Earned equals Taxable Income or Loss

or,

$164,275 (-) 64,918 (-) 23,076 (-) 920 (+) 0 (=) 75,361

**How to Arrive at Cash Flow After Taxes**

There are essentially two cash flows generated by rental income property: That which is produced without any consideration for income taxes, and that which results after the investor meets his or her income tax obligation.

The former is known as cash flow before taxes (CFBT) and is derived by subtracting the property's annual debt service from its net operating income. For example, by subtracting the total mortgage payments of $88,470 illustrated above from the NOI of $164,275 the CFBT is $75,806. This figure is typically shown in a real estate analysis and plays a part in our next computation, but it really doesn't represent the cash the investor gets to pocket after Uncle Sam has taken his bite.

That brings us to a more meaningful bottom line known as cash flow after taxes (CFAT), and explains why it's essential to compute taxable income and loss.

The formula is relatively straightforward:

Cash Flow Before Taxes (CFBT) less Income Tax Liability = Cash Flow After Taxes (CFAT)

Okay, now let's break it down.

The income tax liability is computed by multiplying the taxable income or loss by the investor's marginal tax bracket. For example, say that the investor falls into a 28% tax bracket. We would multiply $75,361 by.28 to arrive at an income tax liability of $21,101 which in turn is subtracted from CFBT to compute CFAT. In other words,

$75,806 (-) 21,101 (=) 54,705

Fair enough, but how do we handle a taxable income loss? For instance, say that the taxable income we computed earlier was a negative $75,361, what then? In that case the income tax liability results in a negative $21,101 and is added to the CFBT which in turn increases the CFAT.

James Kobzeff is the developer of ProAPOD - leading real estate investing software solutions since 2000. Create rental property cash flow, rates of return, and profitability analysis presentations in minutes! Includes computations for taxable income or loss and cash flow after taxes. Learn more at => www.proapod.com

Source: EzineArticles## Article Tags:

### Taxable Income

,### Real Estate

,### Cash Flow

,### Taxable Loss

,### Real Estate Taxation

,### Depreciation

,### Cost Recovery

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