Cash Flow - Before or After Taxes?

Question

When people discuss cash flow, are they referring to the cash flow before, or after, the write offs for depreciation and interest payments?

J Scott · Answer

One other thing to keep in mind is that if you plan to hold property long-term, your tax situation could potentially change many times over the course of your holding the asset.  Don't assume that you financial situation will stay the same or that the tax implications of the particular asset holding will stay the same.

Additionally, don't assume that the tax laws won't change over the course of your holding time period.  From something as small as the marginal brackets changes to something as large as the government deciding not to allow interest deductions or changing depreciation schedules, you never know what can happen over 5, 10, 15, or 30 years.

These are the big reasons why many investor completely ignore the tax implications of their investments -- there are too many unknowns and if anything, the tax implications are likely to be worse in the future than they are today, so if you factor today's implications into the equation, your actual results are more likely to be worse than that, not better.

J Scott · Answer

You shouldn't ignore tax benefits.  But, when talking about real estate "cash flow" in a non-formal (i.e., non-accounting) way, tax implications and depreciation are generally not included.

What many real estate investors do is factor in tax implications after they determine cash flow, and then generate another return measure that includes the tax implications.  This is often called "total return" and also includes accrued equity and any other factors that impact the bottom line.

The big reason for this is that your tax implications may be vastly different than my tax implications, even on the same deal.  So, if tax implications were included in the cash flow number, then when talking about a deal, the cash flow number for you could very well be different than the cash flow number for me.  Instead, we generally ignore tax implications in the cash flow calculation so that we're talking about the same number for all investors, and then let each investor do another calculation to determine the bottom line number for them based on their personal tax situation.

Now, all that said, there are also some very formal (i.e., accounting) definitions of cash flow.  And depending on the specific type of cash flow you're talking about, taxes and/or depreciation may be included.  But, these are generally used on corporate financial statements.  You may hear terms like "free cash flow," "operating cash flow," "financing cash flow," etc.  These are more formal accounting terms, and may include things like taxes, depreciation, etc.  But, that's generally not what we're talking about here when we say, "cash flow."

J Scott · Answer

Cash flow is generally NOI minus debt service, which is pre-tax (and therefore doesn't include depreciation either).

It does include the interest portion of the debt service.

Joel Owens · Answer

Hi Steve,

It's true taxes are always changing in some part of the code.

What it sounds like you want to know is your "tax equivalent yields". This is your cap rate and returns going in added to the tax benefits. So for example an investor say gets a 7 cap for  a purchase but after tax benefits can extract into the double digits.

Everyone's tax situation is different so of course a listing broker or a seller isn't going to give an example. I usually list a commercial property with the cap as that is what most buyers look at and then the buyer runs their own tax projections and returns and talks with their accountant. You have to figure out how important the tax component plays into your purchasing decision on a particular asset.

Steve N. · Answer

Thanks for your info J.

I think it is important for me to determine the cash flow I am looking for after taxes and use that.

And when I have discussions with others, I'll keep in mind that unless they specify otherwise, they are likely referring to pre-tax benefit cash flow.

Steve N. · Answer

I appreciate the fact that the advice here is very conservative. It puts the work "up front" to find a good investment, rather than the work later to recover from a bad investment.

I do question the idea that the cash flow is before the tax benefits though. I thought that the tax benefits are one of the reasons RE is a good investment, so to ignore them seems odd when assessing a deal.

Steve N. · Answer

Man oh Man! How to find anything with cash flow with the criteria around here?

The 50% rule was hard to get used to. Now the expectation of cash flow is before including tax benefits.

Maybe my market just isn't good for rentals.

Cash Flow - Before or After Taxes?

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