How to Calculate Cash Flow from Rental Property

Calculating the cash flow from an investment in rental property will tell you whether your investment makes economic sense. Here's how to do it.

First, calculate taxable income or loss from the property. Taxable income or loss is rent received minus three types of expenses: operating expense, depreciation, and mortgage interest expense.

Assume the purchase of a single-family house for \$125,000, of which \$25,000 applies to the land and \$100,000 to the building. Depreciation of the cost of the building is a tax deduction even though depreciation is not paid out in cash each year. However, the deduction must be spread over 27.5 years. Divide the \$100,000 cost of the building by 27.5 years. Your depreciation expense is \$3,636 per year.

Assume a cash down payment of \$30,000 and a mortgage loan of \$95,000 for 25 years at 10%. The first year's payments would be \$10,359 including about \$9,459 of tax-deductible interest.

Suppose the property is rented for \$12,000 a year, and the total of operating expenses paid by the owner, such as property tax, insurance, and repairs, is \$2,500. Subtract from rental income of \$12,000 the three types of expense: depreciation (\$3,636), interest expense (\$9,459), and operating expense (\$2,500). The result, for tax purposes, is a rental loss of \$3,595.

The tax rules on rental losses are different if you're a real estate professional. But if you're not a professional, here's how your rental loss could affect your income tax.

If you actively manage the property and your adjusted gross income does not exceed \$100,000, the rental loss (up to a maximum of \$25,000) could be deducted from other income such as salary, interest, and dividends. Multiply the rental loss by your federal income tax rate (in our example, 31%). The federal tax avoided as a result of this deductible rental loss is \$1,114.

Cash flow can now be calculated:

 Rental Income   Plus: Tax savings   Less: Operating expense   Less: Mortgage payments \$12,000 +    1,114 -    2,500 -  10,359 CASH FLOW =    \$255

The investment just about "breaks even" on cash flow. The owner's equity in the property increases each year as the mortgage loan is paid down. Any increase in the value of the property during the years of ownership will increase the owner's ultimate return.

Calculating the cash flow on a rental property investment you're considering will help you decide whether the investment is a good one. You may want to avoid investments with a negative cash flow because you'll have to come up with additional money to cover operating costs and debt payments.

 If you need assistance in evaluating rental property investments, please call our office or send your questions to us via e-mail.