Why a Prudent Real Estate Analysis Requires Both Cash Flow Before Tax and Cash Flow After Tax

Real estate investors and real estate investing analysts generally seek to know the cash flow after tax (CFAT) when evaluating the profitability of investment income properties during a real estate analysis because it includes the elements of tax shelter and shows the cash an owner might expect to receive from a property after Uncle Sam takes His 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?

Understanding 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, cash flow is in effect all the income produced by a rental property less all of the expenses required to own the property.

When you take in more money then you spend (i.e., money is leftover after all the bills are paid) the cash flow is "positive" and therefore available for you to take off the table and allocate elsewhere. On the flip side, if you spend more than you take in it results in a "negative cash flow" that requires you to pull money from your own pocket (i.e., outside the property account) to make up the deficiency, therefore creating a vacuum you must fill without any hope of residential cash.

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.

Here's an example of how to compute it.

Say, for example, that your income-producing property produces an annual rental income (after vacancy allowance) of $58,000, operating expenses of $23,000, and the annual loan payment is $25,000. Your annual cash flow before taxes (CFBT) would be $10,000 (which is still subject to taxation).

What is CFAT?

Cash flow after tax essentially signifies that the cash flows produced by the investment real estate property have been adjusted with regard to taxes and as such does take into account any income tax liability that the owner encounters as a result of operating the property. The computation is straightforward: 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 represents the amount of income produced by the property that is subject to taxation. In this case, the property's net operating income (i.e., income less operating expenses) is first converted to taxable income. This is accomplished by taking the net operating income and deducting for depreciation, mortgage interest, and amortized loan points. Then the taxable income is multiplied by the investor's marginal income tax rate (i.e., combined fed and state) to compute the investor's income tax liability.

Okay, let's consider the following 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) To begin with, we must first determine the taxable income. We do this by taking the net operating income of $32,833 and subtracting the total deductions taken of $31,870, which in turn results in a taxable income of $963.

2) Secondly, we multiply that taxable income of $963 by the investor's marginal tax rate in order to calculate the owner's income tax liability. In this case, we'll assume that the investor's marginal tax rate is 38%. Therefore, the resulting taxable income equals $366 (963 x .38).

3) Lastly, we solve for the cash flow after tax by subtracting that tax liability of $366 from the cash flow before tax (or CFBT) of $8,658. So we take $8,658, subtract the $366, and we have determined that the cash flow after tax (or CFAT) is $8,292. It should be pointed out, though, that when the tax liability is a negative amount it would mean that the investor lost money that year by owning the property 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 compare what the CFBT was to the CFAT so you can understand why this is important to real estate investors doing a rental property analysis. Whereas before taxes, we were seeing a cash flow of $8,658, after the Feds take their cut we see $8,292. Granted, not that significant from our example, but you get the idea. There may be times when there is a significant difference. Therefore you would not want to invest in a rental property without full consideration of what the tax implications might be by owning that property.


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James Kobzeff is the developer of ProAPOD - superior real estate investing software solutions since 2000. Create a rental property cash flow, rate of return, and profitability analysis in minutes! Includes full consideration for the elements of tax shelter. Cash flow before taxes and cash flow after taxes are computed automatically! Learn more => www.proapod.com