negative cash flow but postive ROI through taxes

[Mike Sola]

Hey everyone!

I was listening to BP episode 335 or 334 and I heard something interesting. The speaker mentioned that either he or someone he knew invested in a very expensive property which had negative monthly cash flow. However, due to tax incentives, he was still able to maintain a positive ROI every year. Could someone please explain?

Thanks in advance!

[Costin I.]

@Mike Sola - a very simplistic way to calculate depreciation is to take 75% of the property acquisition cost and divide it by 27.5 - that will give you the annual depreciation for a residential property. 

Let's say you acquire a rental for 200K. You have to separate the land from the structure (and you can find how is that considered from the county records and/or tax appraisal or from the insurance) - but for simplicity, let's say 50K is the land value, and 150K (75%) is the structure and improvements value, which constitutes the depreciable basis. For a residential, that gets depreciated over 27.5 years as per IRS, so if you divide by 27.5 you'll get your annual depreciation =  $5,454, let's round it up to 5,5K

[Again, this is simplified as things get more complicated in the first year when depreciation is prorated and get even more complex if you accelerate depreciation with a cost segregation].

So, now if you have positive cash flow of, let's say 10K, you''ll have to subtract the depreciation and end up with a taxable rental income of 4,5K. 

But if you have only 1K positive cash flow, then when you subtract depreciation, you'll end up with a loss of 4,5K. And you can use that against your other income (like salary) to offset some of the taxes there.

So let's say your other income is 100K for which you have to pay, again for simplicity, 25% in taxes. You get to deduct your losses from that income (100 - 4.5= 95.5K) , thus having to pay 25% on only 95,5K, thus saving you $1,125 (or generating 1,125 for you). So, in fact, your rental gave you 2.1K  (1K in cash flow, and 1.125K in tax savings from other income).

Of course, this is actually more complicated as the income above is the AGI - adjusted gross income = an individual's total gross income minus specific deductions, the tax % corresponds to your tax bracket, the deduction applies to 100K income, gets prorated up to 150K and then you can't use it (if you make more than 150K AGI, you'll not be able to deduct the rental losses...unless...and there is layer after layer of complexity).

So, yes, depending on a carefully alignment of stars, you can have negative cash flow and, due to your specific tax situation, end up saving money. I would not call that positive ROI, since I don't see how you can calculate a positive ROI with a negative cash flow (unless you factor in property appreciation or other yet to be fulfilled promise or subjective idea).