Cash on Cash Returns with Taxable Equivalent Adjustment

2 Replies

Hey BP,

I've been researching and searching intensely for the past month or so. I'll bold my key questions.

My question is Cash on Cash Returns and comparing them to other forms of investment.  When I am looking at real estate,  I view the cash flow as an alternative to fixed income preferred stock which provides say 5% in annual yield before taxes.

When I am comparing it to Cash on Cash returns, I feel that the straight calculation doesn't adjust for the tax benefit of the return.

I hope to understand this correctly, the cash on cash return is before we apply depreciation for tax purposes so wouldn't the cash on cash need to be adjusted for a taxable equivalent yield?

If you're net income before depreciation is $2,500 on a $200k property, assuming 27.5 yr straight line depreciation, your depreciation expense would be ~$7k, so you're reporting $0 in taxable income.  So if an investor is targeting a 5% Cash on Cash return for a house with say a 30% tax bracket, the taxable equivalent yield would be 7.14%? Just using basic math for simplicity.

Would you be carrying the credit of the difference of the loss ($4,500/year) towards your capital gains base when you eventually sell it down the road?

I'm trying to make sure I'm understanding this correctly and trying to see if my threshold to invest should be lower once you factor the tax advantages of real estate.

I would welcome any feedback or poking holes.  Hopefully I wrote this logically and not too confusing but I've been confusing myself. Thanks everyone!

@Kevin Chin

Basically, yes...  I think its not "pre-calculated" since it would vary from to person depending the investment situation and their tax situation.

Your second question...  Are you referring to the depreciation unrecapture?  When you go to sell you are taxed at your ordinary tax rate capped at 25% on the depreciation that you were required to take.  The amount above your cost basis is appreciation which is subject to capital gains tax.  It all depends on what is the current tax code when you go to sell (assuming you don't do a 1031).

Given your example, the cash on cash return is really a post-tax amount to your income. Do you any other similar income streams to consider? Perhaps such as Roth IRA...

Just realize that the calculations get more complicated...  When you make a capital improvement (new water heater, new roof, etc.), you need to depreciate those costs according to the IRS' schedule.  So, the annual effective depreciation amount changes.  Also, your rents and front end expenses will change over time.

Hope this helps.  Good luck.

Thanks David. Yes, I realize everyone is different but at least it makes to include some kind of cushion when comparing to taxable fixed income alternatives.

I'd normally be doing a 1031 exchange so the question is probably not relevant.

Again thanks for your thoughts!