I'm reading Real Estate By The Numbers and I had a question: I was reading about Taxable income, which is the amount a property will be taxed in a given year by using the formula [Taxable income = NOI - Mortgage interest - Depreciation - Amortization]. Then I read later on about Cash flow after taxes that used a tax rate of 35% and used the formula [Cash flow before taxes = NOI - debt service - capital expenses + loan additions]. Why would someone use the Cash flow after taxes equation if I'm always going to use the taxable income formula to figure out how much I'm going to be taxed on?
I think any property purchased in 2023 will likely not result in positive taxable income. Property values are high which results in high depreciation costs. Interest rates are high which results in high interest costs.
With that said, I think Taxes should be factored when you think about investment opportunities but with real estate, there are a lot of ways not to pay taxes on your rental income.
I think any property purchased in 2023 will likely not result in positive taxable income. Property values are high which results in high depreciation costs. Interest rates are high which results in high interest costs.
With that said, I think Taxes should be factored when you think about investment opportunities but with real estate, there are a lot of ways not to pay taxes on your rental income.
The 2nd formula is useless. Almost nobody pays 35% tax. Heck, it doesn’t even talk about depreciation. Ignore that person/book.
But income and cash flow are never the same. You’ve got depreciation and principle pay down lowering and raising taxable income and Chas flow in opposite ways.
Like with anything, its just numbers to work with for different points of view.
I'm not really going to address the two equations directly --- everybody comes up with different equations and it just makes my head spin sometimes. But..
Knowing your taxable income is important to see what are you reporting to the IRS to determine your tax liability. However, you also want to know what is your cash flow (some might even call it "profit") without depreciation. I think this where these two equations are trying to get to, although I'm no sure if you are getting them from the same book. Both sets of numbers are pre-tax numbers.
The "second," without depreciation, shows you how much actual cash is leftover, i.e. cash flow. Remember, depreciation is a non-cash deduction --- you didn't actually spend anything to get that deduction (other than purchasing the property and renting, of course).
It could be that your taxable income is actually negative. So, you wouldn't be paying any tax. However, your cash flow is actually positive. Now, you actually have more money in your bank account. This is where depreciation is kicking. From the irs' point of view, you are losing money in your endeavour. But, from your point of view (or your bank account or potentially significant other), you have more cash to invest, save, spend, whatever.. This, too, is a very important number.
Just remember, when you sell you have to pay back on that depreciation --- there is no free lunch. "They" sell you on how great depreciation is.. However, you have to take it. So, its just "lemonade out of lemons..."
I hope that helps. Happy to chat if you'd like. Good luck.
