Net income doesn’t necessarily translate to cash flow or allowing the depreciation factors to come into play for tax purposes.
First, let’s discuss net income and what truly it represents. Net operating income equals the total of all the revenue from the property minus all the necessary operating expenses.
NOI or Net Operating Income is a before tax figure and it excludes principal and interest payments on loans capital expenditures and depreciation along with amortization.
Net operating income is on the property’s income and cash flow statement if there’s a negative figure it is called the net operating loss.
The Net Operating Income figure also helps to calculate what the true capitalization rate is for the property. Dividing the net income by the price purchased gives you the return percentage the buyer can expect to receive for the dollars spent on the property.
Cash flow is far different than Net Operating Income. Cash flow is the moving of the amount of cash in and out of the property after paying its debts and its expenses.
Since expenses fluctuate such as snow, parking lot maintenance, painting and other maintenance items the cash flow can change with the expenses increasing or decreasing.
If there is a positive cash flow the owner can plow the cash flow back into the property, pay the investors a return or simply use it to pay down debt. Just because you have a positive net income result doesn’t mean you have a cash flow result.
Depreciation, on the other hand, is an accounting method of allocating the cost of an asset over its useful life. The investor uses depreciation to offset taxes paid each year on the income produced from the property.
Thus, as an example, if you collected $100,000 net income from the property and you had $30,000 worth of depreciation against the building, the investor would end up paying a tax on $70,000 instead of $100,000 that year.
The higher the tax bracket, the more the investor’s will save for depreciation benefits on taxes paid. There are several ways of taking depreciation against properties one using 39 1/2 years for commercial property, one for residential property of 27 1/2 years and the other can be fast-tracked component part depreciation which could be equivalent to closer to 15 years.
High tax investors like to track depreciation to write it off against his high income while they’re earning.
The land is not depreciable, this value must be subtracted out at the beginning from the overall purchase price paid. Simple general rule of thumb is 15 to 20 percent of the total value is for land.
Always check with your CPA for guidance on this issue. The remaining portion of the value of the asset can be divided yearly by the different numbers mentioned above to give you a steady depreciation a year against income earned reducing your tax consequences.
Don’t forget many properties are purchased for all-cash or have a 60% to 70% loan against them. This will significantly change the cash flow against the property due to the loan payments.
If your current net income is let’s say $100,000 a year but your loan payment is $60,000 a year it has reduced your cash flow significantly after the payment has been taken out of the net income.
So, you can see right away cash flow is higher or lower depending greatly on loans and capital expenses the owner decides to reinvest in the property per year.
Your ending tax consequences will reflect the amount of depreciation you set up over a period of time on the real estate property in question.