# What Is The Formula To Compute The Return On Assets How to Compute Taxable Income or Loss to Arrive at Cash Flow After Taxes

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## How to Compute Taxable Income or Loss to Arrive at Cash Flow After Taxes

The profitability of a rental property is of course measured by the amount of cash flow generated by the property. What a real estate investor always wants to know when considering the profitability of their property each year is “How much did I make?” And this is resolved by considering the property’s cash flow plus or minus the investor’s taxable income or loss.

To calculate taxable income or loss, we must first determine the property’s net income (NOI). Net operating income is gross operating income less operating expenses. For example, suppose a rental property generates annual rental income of \$205,993 and annual operating expenses of \$41,718: the NOI would be \$164,275.

We then subtract from this amount the annual amounts of loan interest paid, depreciation and amortization, and then add any interest earned to calculate taxable income or loss.

Okay, let’s break it down and then show the formula. It’s more meaningful that way.

Interest paid

The annual interest amount you pay on your loan each year is simple. For example, say you made a total mortgage payment of \$88,470, of which \$23,552 was applied to principal: the total interest paid during that year was \$64,918.

Depreciation

Depreciation is more complicated because it depends on the type of property being depreciated and what percentage is set aside for improvements (land cannot be depreciated).

Depreciation (or “expense recovery”) is defined in the tax code as “a decrease in the value of an asset over time as the asset is used,” and the tax code allows owners to take a tax deduction each year up to the total value of the asset. the asset is written off. The amount of the depreciation deduction depends on the “useful life” of the income property, which under the current tax code is 27.5 years for residential property and 39 years for commercial (non-residential) property.

For our example, let’s keep it simple and just say that our income property’s allowable depreciation amount for the year was \$23,076.

Depreciation

This refers to the process of deducting a partial annual tax for an item that you are not allowed to spend in one year and must depreciate, such as “loan points”. Although you pay this premium as a lump sum as soon as you close the loan, you must amortize it over the life of the loan.

Again (for simplicity), let’s assume that the depreciation points allowed by the tax code were \$920 for our given year.

Interest earned

This is about the interest income you may have earned on your income property or perhaps an escrow account that your lender required for property taxes and insurance.

In this case, we simply assume that the interest earned is zero.

The formula

Fair enough. Now that you have an idea of ​​what these components represent, let’s look at the formula.

Net operating income

less interest paid

less depreciation

lower depreciation

plus interest earned

equal to taxable income or loss

or,

\$164,275

(-) 64,918

(-) 23,076

(-) 920

(+) 0

(=) 75,361

How to get to cash flow after taxes

A rental property essentially generates two cash flows: that produced without paying income tax, and that generated after the investor has met his or her income tax liability.

The first is called cash flow before taxes (CFBT) and is derived by subtracting a property’s annual debt service from its net income. For example, subtracting the total mortgage payment of \$88,470 above from the NOI of \$164,275, the CFBT is \$75,806. This number is commonly shown in real estate appraisals and plays a role in our next calculation, but it doesn’t actually represent the money an investor will pocket after Uncle Sam takes his bite.

This brings us to a more meaningful bottom line, called Cash Flow After Tax (CFAT), and explains why calculating taxable income and loss is essential.

The formula is relatively simple:

Cash Flow Before Tax (CFBT)

less income tax liability

= Cash Flow After Tax (CFAT)

Okay, let’s break it down.

Income tax liability is calculated by multiplying taxable income or loss by the investor’s marginal tax bracket. For example, say an investor falls into the 28% tax bracket. We would multiply \$75,361 by 28 to get an income tax liability of \$21,101, which in turn would be subtracted from CFBT to calculate CFAT. In other words,

\$75,806

(-) 21,101

(=) 54,705

Fair enough, but how do you deal with the loss of taxable income? For example, say the taxable income we calculated earlier was negative \$75,361, what then? In this case, the income tax liability is negative \$21,101 and is added to the CFBT, which in turn increases the CFAT.

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