subject: Easy Formula For True Cash Flow After Tax Deduction Or After Tax Cash Flow [print this page] Cash flow formula makes it easier to determine whether a rental property is worth buying. Uncle Sam is kind enough to give you as a rental property investor a great deal of tax breaks by allowing you to deduct your rental property's operating expenses and mortgage payments. Even better, you can deduct depreciation, a "phantom" expense that does not actually occur.
The cash flow formula is, Rental Income - Operating Expenses - Debt Payments. However, your TRUE cash flow is calculated by adding back the tax saving Uncle Sam graciously gives you. Your tax saving is as a result of your rental loss deduction.
Cash flow formula:
Rental Income - Operating Expenses - Debt Payments
Let's continue with an example, a $150,000 single family house with $120,000 loan amount at 30 year 5.5% interest rate. That means debt payments of $8,176 annually.
For $1,000 monthly rent, that is $12,000 annual rental income. You can reasonably factor in the vacancy rate depending on the rental market. Let's assume 7% vacancy rate, this yields $11,160 ($12,000 x 93%) annual income.
Operating expenses are the necessary expenses paid in order to operate the property. Such expenses include property tax, insurance, and repairs. A reasonable figure for this property is $3,000.
With all these numbers, we now have a negative $16 annual cash flow. However, a tax saving can put us back onto the positive cash flow track.
Tax Deductible Rental Loss x Your Federal Income Tax Rate
In this example, rental income is still $11,160 and operating expenses are $3,000.
Mortgage payments usually consist of principle and interest payments (P+I), unless you have an interest only mortgage. The lender will provide you a 1098 form containing the mortgage interest amount for your tax purposes. This amount is gradually decreased as the mortgage term matures. Here we use $6,560, the first year interest payment amount for our example.
Depreciation is a phantom expense that is not actually paid out from your pocket. The IRS rule states that the life of a residential property is 27.5 years, and only buildings rather than land is eligible for depreciation. The value of land and building ratio is usually 1:4. So the building of our $150k single family house is worth $120k. Divide $120k by 27.5 and you get the annual depreciation of $4,364.
Federal income tax rate varies by individual but a good estimate is 30% in most cases.
With these, the tax deductible rental loss is $2,764. (Rental income $11,160 - Operating expenses $3,000 - Debt interest payments $6,560 - depreciation $4,364). The tax saving is $829 ($2,764 x 30%).
As you can see, this turns your annual cash flow from -$16 into positive $813.
