Cash flow is tax free??

[Brody Veilleux]

I'm new to investing and I've been hearing cash flow is tax free. I can run the numbers for NOI-depreciation and this holds true, but not all of the operating expenses are deductible (or at least maintenance, vacancy and cap ex aren't until that money is spent). Am I missing something here?

[Ricky A.]

@Brody Veilleux, to say "cash flow is tax free" is, at best, grossly misleading and, at worst, flat out wrong.

What is true is 1) taxes are based on net income and 2) cash flow does not equal net income.  Therefore, you could say something like "taxes aren't based on your cash flow," but if I were making such as statement, it would be more like "taxes aren't DIRECTLY based on your cash flow" because that better captures the spirit.

You have multiple sets of numbers: 1) [actual] cash flow, 2) net income, and since you mentioned running numbers 3) pro forma numbers (i.e., projected/estimated cash flow).  All three are different.

PRO FORMA vs ACTUAL CASH FLOW: In your pro forma, you may have *allowances* for things like vacancy and CapEx. These are great for setting expectations and as management tools (especially, if you actually set those amounts aside), but they aren't ACTUAL cashflows (even if you do set them aside). They aren't actual incurred expenses and are not deductible.

CASH FLOW vs NET INCOME:  There are three main sources of differences between your actual cash flow and your net income.  1) Mortgage Payments - Only the interest expense (and maybe mortgage insurance) is an expense and deductible.  Principal paydown is not an expense...it's just paying the cost of the asset over time.  Also, escrow payments aren't expenses.  Similar to the allowances in a pro forma, they are simply set asides and only become expenses when the property taxes/insurance are actually paid from them. 2) Capital Expenditures - They certainly feel like expenses, but certain improvements cannot be expensed outright but instead have to be capitalized and expensed/depreciated over time.  3) Depreciation - Finally some good news!  Depreciation represents expensing the cost of the asset over a period of time.  It acknowledges that long-lived assets (i.e., assets that tend to produce income for more than a year) are expensed over a specified "useful life."  Depreciation isn't an actual cash outflow [because we+the bank made the actual cash outflow at closing], but we get to write off the cost of the asset as an expense over time.

Since cash flow doesn't equal net income, there are different scenarios that can happen. 1) Cash flow can be higher than net income.  Like @Sean Graham said, you can have positive cashflow but zero or negative net income-->and thus no taxes. This is generally when depreciation pushes an otherwise positive profit to zero or below. HOWEVER, 2) you can also have situations where net income can be higher than cash flow. In fact, you can have a tax liability even with negative cashflow. This will often happen when a CapEx need wipes out all the cash flow yet has to be expensed/depreciated over time. It could also happen if you have large principal payments that outpace your other operating income.

Hope this helps.