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When judging whether or not to buy a rental property it’s important to calculate cash flow. Calculating the cash flow from an investment in a 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. The loss or taxable income is simply the rent received minus three types of expenses: The depreciation, the mortgage interest expense, and the operating expense.
In this example let's assume you purchase a single-family house for $125,000. Let's also assume $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. The deduction must be spread over 27.5 years. Next divide the $100,000 cost of the building by 27.5 years.
That would mean your depreciation expense is $3,636 per year.
Now let's assume you put a cash down payment of $30,000 and a mortgage loan of $95,000 for 25 years at 10%. That would bring your first year's payments to $10,359 including about $9,459 of tax- deductible interest.
Now being a rental let's suppose that it's 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.
You would then deduct from the rental income of $12,000 the three types of expense:
Interest expense ($9,459)
Operating expense ($2,500)
$12,000 - (15,595.00) = For tax purposes this is a rental loss of $3,595.00
If you're a real estate professional the tax rules on rental losses are different. 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 could be deducted from other income such as salary, interest, and dividends. (Maximum allowable rental loss is ($25,000) Next you will 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 $12,000
Plus: Tas Savings + 1,114
Less: Operating Costs - 2,500
Less: Mortgage Payments - 10,359
CASH FLOW = $255
In our example, this investment just about "breaks even" on cash flow. As the mortgage loan is paid down the owner's equity in the property increases each year. Also any appreciation 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. Avoid those investments with a negative cash flow because you'll have to provide additional money to cover operating costs and debt payments.
That’s an overview of CASH FLOW. Please remember, we are here to answer any of your real estate investing questions!
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