Real estate investing provides a number of tax advantages for investors. This is because not all expenses impact a real estate investment’s cash flow. An investor can show a loss on their investment but still have positive cash flow. That is the difference between pre-tax and after-tax cash flow. Let’s see how it works.
We’ll go through the calculation details using a $1,000,000 residential property that generates $10,000 per month in rental income.
$10,000: Rental income
+ $1,500: Other income (pets, views, laundry machines, covered parking, garages)
= $11,500: Total income
Subtract vacancy allowance, bad debt, and promo/free rent
- $1,000: 10% general vacancy loss
- $500: Credit loss or bad debt
- $500: Free rent
$9,500 = Gross income
Subtract operating expense:
$550: Property taxes
$450: Insurance
$1,000: Repairs and maintenance (10%)
$1,000: Property management (10%)
$500: Other fees
$6,000 = Net operating income (NOI) — 60% of rental income
- $5,000: debt service (assuming 20% down at 6.5% interest for 30 years)
= $1,000: Net monthly cash flow — 10% of rental income
$12,000: Annual cash flow
The above calculations show that the property should add $1,000/mo to the investor’s bank account or $12,000 per year. Note that we haven’t accounted for capital expenditures or related savings.
The $12,000 from above isn’t the investment’s profit or the amount that will be taxed. Instead, it is called the pre-tax cash flow, which is positive in this case. We still have to factor in depreciation to get the after-tax cash flow.
Using straight-line depreciation, the depreciation expense will be ~3.6% of the property’s value or $36,000 per year. Once this figure is taken into consideration, the property made:
$12,000: Pre-tax income
- $36,000: Depreciation
= -$24,000
Factoring in depreciation, the property did not generate a profit and showed a loss for the year. However, this is a paper loss since the property has a positive cash flow. The investment still has $12,000 in the bank for the year. That’s why depreciation is referred to as a paper expense.
There are no taxes owed on this property because it did not generate a profit. So there is nothing to tax. If the property had made a profit, the investor would have paid taxes depending on their tax bracket. After paying taxes, whatever is left would be the after-tax cash flow.
This investment is taxable. Some investments are tax-sheltered, such as those in certain DSTs. In other words, the income on tax-sheltered investments isn’t taxed.
Tax situations are complex and unique to each individual. That’s why it is important to speak with a tax advisor when seeking advice on tax scenarios.