One of the calculations you’ll want to learn when you start investing in real estate is the after-tax cash flow, which is the cash flow that’s left after debt service, operating expenses, and taxes. In most years, you would hope to see an after-tax cash flow that’s positive, but it’s not unusual for it to be negative in a year where you’ve made large investments into the property.
Determine Net Income
The most important first step in calculating after-tax cash flow is to determine your net income for the year. According to the IRS, rental income is “any payment you receive for the use or occupation of property.” Rental income can include any of the following:
Normal rent payments: This type of rental income is self-explanatory and generally includes the normal rental income you receive from your tenants each month.Advance rent payments: Rental income can also include any rent you receive before the period it covers. Security deposits are also considered advanced rent payments.Payments for canceling a lease: Rental income can include payments your tenant gives you to cancel a lease before it’s scheduled to end.Expenses paid by the tenant: If your tenant pays for any repairs or expenses that would otherwise be your responsibility, they’re considered rental income.
Once you’ve calculated your gross rental income, you can find the net income by subtracting your operating expenses. These can include maintenance, insurance, administrative expenses, debt service, and any other expenses you incur. However, you shouldn’t include tax expenses or deductions here.
Determine Taxes Owed
Once you’ve determined your net income, you can figure out how much tax you’ll owe on that income. The good news is that in addition to reporting your rental income, you’ll be able to report and deduct your real estate expenses and depreciation. According to the IRS, you can deduct “the ordinary and necessary expenses for managing, conserving and maintaining your rental property.” Examples of ordinary and necessary expenses include:
MaintenanceAgent’s commissionUtilities and management feesInsuranceLegal servicesInterestState taxesDepreciation
You’ll have to report the following information:
The physical address of the propertyThe number of fair rental and personal use daysThe type of propertyRent receivedExpenses
Your net rental income is taxed at your ordinary federal income tax rate, which ranges from 10% to 37%. It’s possible that your expenses will exceed your income—meaning you won’t owe taxes—but your losses will be limited by the passive activity loss rules and at-risk rules. Keep in mind that depending on where you live, you may also be on the hook for state income taxes. How much you’ll owe and how you’ll report that income depends on where you live and the state where the property is located.
Calculate Cash Flow After Taxes
Once you’ve determined your net rental income and taxes owed, you can easily calculate your after-tax cash flow. The formula will look like this: After-Tax Cash Flow = Operating Income - Operating Expenses - Debt Service - Taxes Owed A simplified version of the formula would be: After-Tax Cash Flow = Net Income - Taxes Owed
The Bottom Line
Knowing how to calculate your after-tax cash flow is an important part of real estate investing. This calculation gives you the most accurate view of your real estate income. While looking at your gross income—or even your net income—might give you some idea, they aren’t fully accurate unless they include all of your expenses and taxes.
