Cash flow, that monthly bank deposit of rent collected in excess of operating expenses is a major consideration when investors evaluate a rental property. Sometimes new investors forget one component of cash flow simply because they don't see it every month. Think of cash flow not as a calculation for the property's income minus expenses, but more as how much cash left your wallet during the year versus how much came in.
The best way to show how depreciation can make a major difference in ROI, Return On Investment, is to use an example situation. Here are the components:
•Rental home worth $187,000 (structure, not land).
•Rent collected each month of $1305.00.
•Mortgage payment of $877.00 with escrows.
•Operating expenses of $1800/year.
•Total cash out/month of $1,027.
•Positive cash flow of $1,305 - $1,027 = $278.00/month
Now, let's look at our tax bracket and the income property depreciation deduction. We're in a 35% tax bracket. We can depreciate this rental home over 27.5 years. Dividing the $187,000 structure value (land doesn't depreciate), we get an annual depreciation deduction of $187,000 / 27.5 = $6,800. That's $2,380 cash out of pocket as income tax due at our 35% tax rate.
$2,380 / 12 = $198/month we are not paying out for taxes. Adding that to our previously calculated $278/month cash flow, we actually are enjoying a real cash flow of $476/month. That's quite a difference.
Another Cash Flow Component
That's great, and makes a major difference. But, let's think about our mortgage as well. To this point, we've just taken the cash paid out of pocket for the debt service into account. However, we also get to deduct the mortgage interest as well. So, if your mortgage interest paid this year is $8,400, we have another deduction to add to expenses.
At our 35% tax rate, the $8,400 saves us $2,940 or $245/month in tax paid out of pocket. Now things get really interesting. Adding that back to our newly calculated $476/month, we're not getting an effective cash flow of $721/month! It doesn't take an accountant to see the major difference in the original $278 number and this one.
If you've wondered what draws investors to real estate, this is a big part of the attraction. They're not getting these tax breaks in the stock or bond markets. Taking just the operating expenses into account for true cash flow isn't giving you a complete picture of the value of a rental property investment. Factor in these tax advantages and things take on a whole different perspective!