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What Is The Difference Between Cash Flow And Profit?

Sometimes profit and cash flow are misunderstood. Calculating cash flow is easy. Monthly cash flow is simply the remaining funds an investor has each month after collecting rent and paying all property expenses. Subtract the mortgage payment, insurance, property taxes, mortgage insurance (if applicable), and any other expenses or repairs. The remaining funds are the monthly cash flow. However, profit is a different calculation.

An investor who owns rental property is able to deduct mortgage insurance, property taxes, mortgage interest, repairs, leasing, and management fees. Improvements made to the property can also be deducted, but usually over several years. For example, adding a new fence or sprinkler system would be considered improvements, and the IRS requires you to deduct this type of improvement over five years.

One key in calculating profit is the monthly and/or yearly principle payment. An investor cannot deduct principle. The principle component of a mortgage payment is not a deductible expense. Instead, the IRS allows investors to depreciate the improvement of the home (Purchase price – land value) over 27.5 years for a single family residence.

For example, let’s take a typical purchase of a $125,000 single family residence. If investor financed 80% of the purchase price on a 30 year mortgage at 5%, the estimated mortgage payment would be:

Principal Interest Payment
$536.82
Property tax Payment
$260.42
Mortgage Insurance Policy
$0.00
Hazard Insurance
$47.01
Total Monthly Mortgage Payment
$844.24

The PI Payment is $536.82, of which $122.95 is the average principle portion over the first 12 months on a 30 year mortgage. This equates to $1,475 the first year. Even though you are writing a check for the entire mortgage, the yearly $1,475 cannot be deducted on your Schedule E of your tax return.

Now let’s calculate cash flow and profit assuming a monthly rent of $1,150, $600 in yearly repairs, and a 7% monthly management fee. Below are the calculations for cash flow, profit before depreciation, and profit/loss after deducting depreciation:

Profit Analysis Before Depreciation
Monthly
Yearly
Rent
$1,150.00
$13,800.00
Repairs
($50.00)
($600.00)
Property Taxes
($260.42)
($3,125.04)
Hazard Insurance
($47.01)
($564.12)
Mortgage Interest
($413.87)
($4,966.44)
Management Fees
($80.50)
($966.00)
Total Profit (before dep)
$298.20
$3,578.40
Cash Flow Analysis
Monthly
Yearly
Add Principle
$122.95
$1,475.40
Total Cash Flow
$175.25
$2,103.00
Profit Analysis After Depreciation
Yearly
$100,000 / 27.5 years
$(3,636.36)
Realized Gain/Profit
$(57.96)
 

As you can see, the property produces a monthly $175.25 cash flow. However, monthly profit before depreciation is $298.20 or $3578.40 yearly. Once you factor in depreciation, your profit is wiped out making the profit tax free. Even if your adjusted gross income exceeds $100,000, you are able to realize the gain tax free in this scenario. You are limited to writing off losses once your adjusted gross income (AGI) exceeds $100,000. However, when you get further into your amortization schedule, your interest will decrease and the amount of principle paid will increase. As the principle payment increases, so does your profit. Property taxes will also change yearly.

The above example is pretty accurate of what an income producing property can generate as far as cash flow and profit. For 2012, rents are high, sales prices are low, and interest rates are rock bottom- all factors (rents, mortgage rates, and sales prices) favour the landlord. I have never seen a better opportunity for landlords to invest in rental properties.

If you have any questions, please call us at 512-257-9836. Our office provides sales, leasing, property management, and mortgage services.

Posted by: smartsourcerealty on April 7, 2013
Posted in: Uncategorized