Do you count the principal paydown portion of the mortgage payment as an 'expense' or 'income' or 'neutral' in your cash-flow analysis?

Question

Isn't it just cash directly into your net worth?

When everyone talks about clearing $100 a month for their rentals are they counting principal paydown as part of income or expense?

Michael Smith · Answer

Hi @Nick Matteson , great question. In accounting, analyzing cash flow is different than calculating profit. Cash flow is simply the cash that comes in minus the cash that goes out over a certain period of time. It is important to make sure that you will have positive cash flow, because its hard to pay the bills with equity. Cash is king.

Where it gets more complicated is looking at income and expenses, to calculate net profit as taxable income for Uncle Sam. The principal portion of your mortgage payment is not an expense. Instead, you have a non-cash expense called depreciation that reduces the book value of a long-term asset such as a property.

When running your business, you will want to regularly generate three key reports: (1) Income Statement, (2) Balance Sheet, and (3) Cash Flow Statement.

The Income Statement is where you keep track of income and expenses in order to arrive at a Net Profit, following a very specific method in case of an IRS audit so that you claim the correct amount of income and pay the correct amount of taxes. Here's a brief example:

Gross Rents (Income) - Property Taxes (Expense) - Insurance Premiums (Expense) - Repairs & Maintenance (Expense) - Property Management Fees (Expense) - Interest (Expense) - Depreciation (Expense) = Net Profit, or Taxable Income

Note that the principal portion of your mortgage payment and capital expenditures are not deducted as expenses. Instead we use depreciation, following the specific schedules provided by IRS guidelines. Assuming that you are in the early years of your mortgage, the majority of your payment will be interest and once depreciation is included it is possible that your net income will be negative even though you may have positive cash flow. This is why so many people love real estate!

Now let's look at the Balance Sheet. This is simple Assets (things you OWN) - Liabilities (things you OWE) = Equity.

The Cash Flow Statement is critical, because this shows how much actual CASH went in and out of your business over a period of time. Here's an example:

Collected Rents - Mortgage Payments (entire PITI, or Princiapl, Interest, Taxes & Insurance) - Repairs & Maintenance (even capital expenditures which are not deducted in current year's Income Statement) - Other Cash Expenses (such as property management, etc.)

The goal for most buy-and-hold investors is to purchase properties that generate positive CASH FLOW, even if you can claim a net loss on paper with your Income Statement when filing your taxes.

Principal paydown over time is great, but the number one reason why businesses fail is improper management of cash flow. If you're paying down your mortgage balance by $1,000 every month but you're losing $500 a month in actual cash flow... Sure, the net effect is a gain, but eventually this will become unsustainable unless you have immense cash reserves, because cash is the blood that keeps a business running. If your cash supply dwindles down to nothing its hard to keep a business running unless you can tap into that equity and turn it into more cash.

Hope that helps! =]

Ellis San Jose · Answer

It technically isn't cash but "earned" equity that affects the balance sheet (net worth) not the income statement.

Nick Matteson · Answer

Thanks,

I see why the IRS sees it as earned income. But I see that technically it doesn't exist unless I sell my properties, so I won't count it in the cash flow.

Bill Gulley · Answer

Four areas, two statements and  (one is not a statement but an analysis) is your income and balance sheet, the analysis is the "budget". A fourth is your Use of Cash.  A cash flow analysis can be as simplified as your home budget excluding equities or economic benefits or complicated to include projections, like expected loss of rents, repairs and the use of cash with other benefits. There are no real set standards as to budgeting or cash flow analysis as they are devised to the size, scope and uses of the business. You can combine a cash flow analysis and budget. These are "in house" reports for business operations and not a required statement for accounting purposes. You can certainly have other reports generated as well, sales and income, sales and expenses, etc; These are simply areas of managerial accounting.

When someone says they get $100.00 per door, I'd say they usually mean what they put in their pocket without that money being committed to anything related to the property. However, since many don't have significant cash reserves, that hundred bucks can easily be needed for some unforeseen future matter as well, meaning they may not really be getting that hundred bucks a door as they think. :)

Deborah Burian · Answer

@Nick Matteson - in the analysis of whether a property will cash flow, we count the entire mortgage payment, principle and interest both.  What the accountant calls it and how it affects the balance sheet has been well covered here by @Michael Smith and others but the reality is, after you receive your rent check, you have to pay your mortgage.

Mike Giudici · Answer

Debt service would be listed as an expense when doing a cash flow projection.

Nick Matteson · Answer

Thanks @Michael Smith for the great, detailed explanation.

I calculated both the (1) Income and (2) Cashflow prior to all purchases and so knew with some degree of certainty what I was getting into beforehand, including all the items you listed. My focus on cashflow was of the most important factor in the decision for each home, so I do have positive cash flow including all costs (even if initially it is only a little for each property.) It is still early days for the mortgage, and rents have not appreciated much yet.  Deborah Burian

Matthew Newcomer · Answer

@Michael Smith - thank you so much for this in-depth response.  This is the best explanation I've seen and answers a nagging question I've had for a long time re: why principal payments are not included on the income statement.  Thanks again!

Stephen N. · Answer

cash flow? no

return on investment? yes

Do you count the principal paydown portion of the mortgage payment as an 'expense' or 'income' or 'neutral' in your cash-flow analysis?

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