Spreadsheets: Should depreciation and taxable income be included?

Question

Like many of us, I have created my own spreadsheet calculator to analyze multi-unit properties. I am struggling to understand how depreciation and taxable rental income should be calculated in the spreadsheet.

As I currently understand it: Depreciation of property value (not land) can help reduce taxes on rental income. And estimated taxes owed is total income minus total expenses (cash flow) then multiplied by your current tax rate. Am I right?

Does straight-line depreciation increase each year because of inflation, ARV, or annual property appreciation, switching tax brackets, etc?

Should I add estimated income taxes to my non-operating expenses to get a more accurate analysis of cash on cash return?

Should I include inflation to future income tax expenses?

Does inflation need to be calculated at all anywhere in a spreadsheet calculator?

Sorry for so many questions, I'm so confused... Could anyone provide any feedback, suggestions, thoughts?

Jeff B. · Answer

Straight-line is just that; a linear, FIXED amount every year. For long term B&H, this is the right choice. For short term ( 5-7 year plan), use the Double Declining Balance method - - and that's a bear to get right.Forget 'appreciation' as it is not realized until you sell and then you have to deal with Depreciation Recapture too. Also ignore inflation and it's even worse as you can't reasonably estimate this unknown.

Dave Toelkes · Answer

@Frank S.As I currently understand it: Depreciation of property value (not land) can help reduce taxes on rental income. And estimated taxes owed is total income minus total expenses (cash flow) then multiplied by your current tax rate. Am I right?Partly right. Although your debt service reduces your total cash flow, only the interest portion of your loan payment is deductible. So, change your taxable income formula to taxable income = (net operating income) - (mortgage interest) - (depreciation)Does straight-line depreciation increase each year because of inflation, ARV, or annual property appreciation, switching tax brackets, etc?No. Your depreciation is based on the cost of the dwelling structure with a 27.5 year recovery period. Once you have bought the property, your cost is not affected by future appreciation, inflation, ARV, or your tax bracket. Your depreciation expense might be adjusted from year to year for improvements or depreciable replacements you made since your purchase, but there is no adjustment for appreciation, inflation, ARV, tax bracket changes.Should I add estimated income taxes to my non-operating expenses to get a more accurate analysis of cash on cash return.Most investors calculate cash on cash return before depreciation and before taxes. If you want to know your after tax cash flow use this formula: After tax cash flow = (Net Operating Income) - PITI - (Income tax liability). Deprecation is a non-operating expense that reduces your tax liability but not your cash flow. You don't want depreciation included in your cash on cash return.

Denise Evans · Answer

Double declining balance is available as a tax deduction on ONLY personal property, not real property. Otherwise, I agree that you should add lines on your spreadsheet for after tax cash flows.You might want to look into cost segregation accounting as means of accelerating depreciation in early years. A lot of experts advertise their services, but not really necessary as long as you don't try to get too aggressive.You should keep your accounting on a business basis, and then make book-to-tax adjustments. Many "operating expenses" taken by property owners are more accurately capital expenditures and should not affect your NOI for purposes of valuation. In addition, some operating expenses are not NOI expenses, so you need "above the line" and "below the line" to allow for those items, such as advertising and commissions.

Justin Fox · Answer

Like @Jeff B. said, depreciation is a fixed deduction amount, except for probably the first and last years where you would probably use the mid-month convention.I set aside money for income taxes. Right now, due to child tax credits and filing jointly, I pay much less than I otherwise would (so I get a 'return') but I want to be in the habit of setting aside the money for down the road.I would also ignore appreciation and inflation. I'm sure you plan to keep your rents at market rate and that's simply the best you can do. Buy great deals.