Cash flow formula makes it easier to determine whether a rental property is worth buying. Uncle Sam is kind enough to give you as a rental property investor a great deal of tax breaks by allowing you to deduct your rental property's operating expenses and mortgage payments. Even better, you can deduct depreciation, a "phantom" expense that does not actually occur.
The cash flow formula is, Rental Income - Operating Expenses - Debt Payments. However, your TRUE cash flow is calculated by adding back the tax saving Uncle Sam graciously gives you. Your tax saving is as a result of your rental loss deduction.
Cash flow formula:
Rental Income - Operating Expenses - Debt Payments
True cash flow formula:
Rental Income - Operating Expenses - Debt Payments + Tax Saving
Let's continue with an example, a 0,000 single family house with 0,000 loan amount at 30 year 5.5% interest rate. That means debt payments of ,176 annually.
For ,000 monthly rent, that is ,000 annual rental income. You can reasonably factor in the vacancy rate depending on the rental market. Let's assume 7% vacancy rate, this yields ,160 (,000 x 93%) annual income.
Operating expenses are the necessary expenses paid in order to operate the property. Such expenses include property tax, insurance, and repairs. A reasonable figure for this property is ,000.
With all these numbers, we now have a negative annual cash flow. However, a tax saving can put us back onto the positive cash flow track.
Tax deductible rental loss formula:
Rental Income - Operating Expenses - Debt Interest Payments - Depreciation
Tax saving formula:
Tax Deductible Rental Loss x Your Federal Income Tax Rate
In this example, rental income is still ,160 and operating expenses are ,000.
Mortgage payments usually consist of principle and interest payments (P+I), unless you have an interest only mortgage. The lender will provide you a 1098 form containing the mortgage interest amount for your tax purposes. This amount is gradually decreased as the mortgage term matures. Here we use ,560, the first year interest payment amount for our example.
Depreciation is a phantom expense that is not actually paid out from your pocket. The IRS rule states that the life of a residential property is 27.5 years, and only buildings rather than land is eligible for depreciation. The value of land and building ratio is usually 1:4. So the building of our 0k single family house is worth 0k. Divide 0k by 27.5 and you get the annual depreciation of ,364.
Federal income tax rate varies by individual but a good estimate is 30% in most cases.
With these, the tax deductible rental loss is ,764. (Rental income ,160 - Operating expenses ,000 - Debt interest payments ,560 - depreciation ,364). The tax saving is 9 (,764 x 30%).
As you can see, this turns your annual cash flow from - into positive 3.
We also covered a very simple cash flow formula BEFORE tax deduction in another article "Easy Formula for Rental Cash Flow".