Reviewing Rental Property Financials - Most Common Items I've seen

A Common Question I'll get is "Is this good property to invest in?" or " Here are the tax returns from the seller to verify the rents on this property, how will it affect my financing?"

When reviewing a prospective income property's tax return for verification of income you're probably going to be looking at the schedule E on a form 1040 personal return(s) or a 1065 form partnership return(s) some of the reasons accounting income may not be indicative of actual cash flow are because of:

- 1) Depreciation may the not be taken out - This should be added back to income for cash flow purposes since the expense isn't a real world cash expense but rather its a loss allowed on paper.

- 2) Accelerated depreciation - Similar to the above #1,This occurs when you're trying to write off your depreciation in a shorter time frame so you can write off more per year and shield more of your income from tax liability. Instead of a 27.5 year period to deduct it may be as short as 5-15 years depending the useful life of each item. The accelerated depreciation can be added back as well. This tends to show up as "Section XXX Expense" at the last pages/schedules of the tax return. So I would look for this and you can add it back as well from a cash flow analysis point of view.

- 3) Higher than normal Interest expense - could be because the current owner has a private note or a high interest rate loan. This is not your interest expense of acquiring or owning the property so this number can be added back to income and I would recommend to use your own interest expense estimations.

- 4) Principal reduction not factored in - the portion of principal reduction that you pay each month (if your loan is principal & interest) should be factored in when reviewing for cash flow purposes as you'll be needed to pay the full mortgage payment each month not just the interest (unless interest only).

- 5) Amortization expense that is taken - This can be added back to income, because these are usually costs that have been incurred already and the expense had to be taken over a specific period of time or life of the loan. By adding it back as income you can determine the real cash flow of the property in that given year not an expense that occurred when the seller purchased the property years ago.

- 6) Property Management Expenses not factored in - Even if you want to personally manage a building I would consider factoring this expense in to make sure that if you ever wanted to not be a property manager any longer that the property still makes sense financially to hire a property manager otherwise you'll be chained to the property. Most commercial lenders on 5+ units multifamily will factor this in when calculating the NOI even if the financials do not show it, but with residential 1-4 unit lending it is not a forced expense that is required to be factored in.

- 7) Personal Expenses Allocated to Rental Property Return - sometimes the property owners in an attempt to reduce their taxable income may allocate travel, cell phone, meals & entertainment, etc. I would make sure you factor this out to find out how the property is really operating unless these are necessary to operate the property, case by case basis. Generally these are just discretionary personal items allocated for tax liability reduction.

- 8) High Utilities Expenses - its always good to call up the local Utilities company to ask what is a average bill for a structure may be and see where the differences are. Sometimes this may indicate a bigger issue with the property or an opportunity to add value by fixing the issue/sub-metering the property for expense reduction.

9) Capital Expenses that are written off fully can sometimes make the financials look like it property doesn't perform well.If its an item that isn't replaced often it should be added back to income so the normal cash flow figures are accurate. From a lending perspective these items are usually added back to income as well.

10) Other Schedules at the end of the return - sometimes the building is a part of a association and there may be association dues so it may be important to check on this to make sure you've correctly factored in all expenses for operating the property. This is also the area where a lot of other miscellaneous expenses are written off as well.

The above is not tax advice and I am not a tax professional but, this is what I see on a daily basis. Please seek your own tax advisor.