Everyone’s journey into the world of rental properties is a little different. Some made the deliberate decision to become a landlord, while others took a less intentional path and one day found out they were an accidental landlord. Regardless of which route you took, there are two metrics you need to know to understand the performance of your investment. The two metrics are net taxable income and cash flow.
What is Net Taxable Income?
Net taxable income is simply your gross rental income minus your allowable deductions. Unlike cash flow, net taxable income is an accounting number used for taxes and tax planning. Net taxable income is significant because it is the base against which your tax rate is applied to determine your tax liability.
Calculating Net Taxable Income
To calculate your net taxable income, you first need to figure out your gross rental income. The IRS defines rental income as “any payment you receive for the use or occupation of property.” Which in addition to the rent you collect, can include:
- Advanced payments for rent
- Security deposits that you keep
- Services received from your tenants instead of monetary rent payments
After you have your gross income, you’ll subtract all expenses that you can deduct. Which may include:
- Costs of cleaning and maintaining the property
- Mortgage interest (loan principal payments are not deductible)
- Insurance costs
- Advertising cost
- Any management fees paid
- HOA dues or condo fees
- Property taxes
- Services you pay for (utilities, pest control, etc.)
- Legal and other professional fees
- Depreciation (perhaps the most significant deduction)
Let’s look at a quick example:
Monthly Gross Income $2,300
Mortgage interest ($400)
Insurance ($90)
Repairs & Maintenance ($200)
Property management ($200)
Property Taxes ($100)
Depreciation ($700)
Other deductible expenses ($150)
Net Taxable Income $460
Annual Taxable Income = $5,520
What is Cash Flow?
Cash flow is the difference between your rental income and expenses paid. Unlike net taxable income, cash flow disregards whether some things are deductible for tax purposes and focuses on the actual cash in-flows and out-flows of your rental property. Hence, cash flow gives you a more accurate view of whether your rental property is profitable.
Calculating Cash Flow
Let’s continue the example from the net taxable income section. The investor collected $27,600 in rent for the year.
Monthly Gross Income $2,300
Total debt service: interest & principal ($1,000)
Insurance ($90)
Repairs & Maintenance ($200)
Property management ($200)
Property Taxes ($100)Depreciation ($700)
Other deductible expenses ($150)
Monthly Cash Flow = $560
Annual Cash Flow = $6,720
Net Taxable Income vs Cash Flow
You might have noticed that the figures for net taxable income and cash flow are different. The difference is because when calculating your net taxable income, you will not include your mortgage principal payment as an expense; yet, you will include an expense for depreciation. Conversely, when calculating your property’s cash flow, you will not include a depreciation expense but will include your principal payment in your debt service expense. The difference between net taxable income and cash flow allows many landlords to report less income than they received during the year; needless to say, this is one of the most significant tax benefits of real estate.
Final Thoughts
Accurately calculating your net taxable income and cash flow will give you an accurate picture of your rental’s performance, which is key to incorporating your property into your financial plan. Since your real estate investment is likely a large percentage of your overall net worth, it’s crucial that it’s included in your financial plan and aligned with your life goals. As always, if you don’t feel confident in creating your financial plan, or if you would like an expert opinion on your financial situation, you should consult with a qualified financial planner.
