Cash Flow and Taxable Income for Income Property
Cash Flow and Taxable Income
Rental properties are purchased with a set of earnings expectations. Revenue, mostly in the form of rent will be earned and money will be spent for the operating expenses, mortgage payments and improvements to the property. At the end of the year, the objective is to have taken in more than was paid out, while minimizing taxes. "How much did the property earn this year?" The answer lies in an analysis of Cash Flow and Taxable Income.
Taxable Income or Loss.
Remember that mortgage payments are not included in the Net Operating Income (NOI )calculation, so it is now, below the NOI line, that you take financing into account.
When making a Taxable Income calculation, only deduct the interest portion of the loan payments. Interest earned (on our escrow account, for example), must be add back into income. Deductions may be made for depreciation and amortization. Each year a portion of the value of the depreciable asset is deducted, until finally the entire amount has been written off. With real estate, the physical structures (i.e., the buildings) are treated as depreciable assets.
Under current real estate tax law a residential income property is depreciated over 27.5 years, and a non-residential property over 39 years. Since not everyone buys or sells on the first of the month, the tax code tries to even matters out with a so-called "half-month convention" which allows the taxpayer to claim only half the normal amount of depreciation in the month that the property is placed in service, and half in the month when it is sold.
Another item that affects our taxable income is amortization. It is important to understand that the term, as used here, does not refer to the principal portion of a loan payment. Instead, it refers to the process of taking a partial annual tax deduction for an item that cannot be expensed in a single year.
A good example of a cost that must be amortized is the fees paid for a loan, commonly called "points." Typically this premium is paid in one lump sum at loan closing, but it must be amortized over the life of the loan. A 240-month investment-property loan for $720,000 that requires payment of 2 points (2%, or $14,400), means a deduction of $60 per month, or $720 for each full tax year.
In summary, the Taxable Income is our Net Operating Income less interest payments, plus interest earned, and less allowable write-offs for depreciation and amortization. more