Cash Flow Before and After Tax: The Computations and Importance To a Sound Real Estate Analysis

It is common for real estate investors and analysts to conduct a real estate analysis on investment property with full consideration of tax shelter in order to compute cash flow after tax because CFAT reveals the bottom line amount an owner might receive after the Feds take their cut.

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?

What is Cash Flow?

Cash flow is the amount of income that remains after the property's operating expenses and loan payment are deducted from all the income generated by the property. In other words, all the income generated by the investment property less all of the expenses required to hold the property creates the cash flow.

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 generates an annual 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 in essence signifies that the cash flows produced by the rental property have been adjusted for taxes and as such does take into account any tax liability that the owner incurs by reason of operating the property. The calculation is clear-cut: 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 income 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, now let's consider an 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 compute the investor's tax liability. We do this by multiplying the taxable income produced by the property by the investor's marginal tax rate (which we'll say is 38%). Therefore, 963 x .38 equals a tax liability of $366.

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 by owning that property for that given year the investor lost money 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 let me illustrate why knowing this is important to real estate investors doing a rental property analysis. Notice that the cash flow we calculated before taxes was $8,658, whereas here, after the IRS gets paid, we actually get to keep just $8,292. In this case, not that big of deal, but you get the idea. There is a difference. Therefore it just makes sense to always consider the tax implications of owning a rental property before you make the investment.

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