How to calculate after tax cash flow in real estate?

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8 Steps to calculating after tax cash flow

This article guides you through the procedures for creating an after-tax cash flow analysis. The rental house unit is the foundation for the computations here.

The analysis findings depend on choosing an appropriate rate to discount the after-tax cash flows to their present value; thus, it must be carefully considered. The cash flows themselves shed light on the investment's suitability; therefore, it is essential to be aware of the after-tax cash flow analysis's assumptions.

Let’s dive in and understand several steps to calculating the after tax cash flow of any property. 

How to calculate after tax cash flow in real estate

How to derive after-tax cash flows? 

The primary goals of laying out cash flows are demonstrating a property's probable income and calculating fair prices or return measures.

In light of the anticipated dangers, the investor or analyst can determine whether the internal rate of return from the cash flow, including the initial investment, is high enough to warrant buying the property

As an alternative, the cash flows should be discounted at the investor's necessary or desired rate of return to determine the amount of the investment that is justified. Use the following steps to estimate the cash flows from property investment:

Step 1 - Defining the cash flows

There are several ways to define cash flows, but the four methods shown in the table below are the most popular options for real estate investors. It's critical to distinguish between these several cash flows and the implications of each flow study.

Alternative Cash Flows

Alternative Cash Flows

The property's cash flow before taxes is independent of the investor's borrowing decision or tax status. This makes it possible to appraise the property without knowing who the buyer will be, and it is frequently used to support market valuations of assets that generate income.

After subtracting predicted income tax and capital gains tax, the cash flow to the property after taxes is calculated. Still, loans, loan payments, and tax deductions for interest are ignored.

Utilizing this cash flow, one can evaluate after-tax leverage. Property funds may discount this cash flow at their weighted average cost of capital. 

The most explicit of these cash flows is the after-tax equity cash flow analysis, which discounts property revenue after considering mortgage repayments, income taxes, and capital gains taxes. 

Discounting equity cash flows after taxes is helpful in property evaluation, especially for private investors who frequently depend on the advantages of borrowing and tax shelters. 

The after-tax equity cash flows are typically derived by calculating and displaying the property and equity cash flows before taxes.

Step 2 - Select the duration of the analysis.

Once the estimated cash flows have been chosen, a suitable time range for the study is chosen. How long into the future the cash flows will be predicted is the first choice.

After the "holding period," an estimated resale or residual value is required. The timing of the cash flows, often known as their frequency, is the second decision.

The distinct cash flow intervals inside the "holding period" are frequently referred to as "periods" in accounting terminology.

Both judgments are mostly driven by the availability of data, the likelihood of forecast accuracy, and practicality.

The first financial commitment to the plan would mark the start of the analysis for real estate development. Usually, it would conclude with the sale of the finished construction. 

The transaction can be hypothetical if the property developer intends to keep the property as a longer-term investment. Alternatively, if it is believed that this is a more advantageous time to sell, the analysis may go on until a sale a few years after the development is established.

The analysis is typically divided into months or quarters depending on the overall development length and the cost projections' accuracy and precision.

The analysis would start with purchasing a property that has been improved. Depending on the investment objectives, it would either expire when the property is anticipated to be sold or assume a notional sale after five or ten years. Rarely is the analysis longer than ten years, even if the buyer has no plans to sell at that time.

This is due to several factors, including the difficulty in predicting cash flows this far in the future and the minimal impact that distant receipts have on current value (mainly when inflation and risk result in discount rates of about 12 per cent per annum or more).

Long-term institutional investors, such as superannuation funds and life companies, occasionally extend cash flow calculations to a 15-year holding period, but this may not contribute much to the analysis.

Another option is to continue the cash flow analysis until the forecasted net income stabilizes. It may occur when rentals reach the midpoint of their subsequent cycle or when occupancy in a new building reaches its long-term projected average. 

On rare occasions, the cash flow analysis might be postponed until a significant alteration or interruption in the income stream, like the expiration of a lease or an anticipated renovation.

Although most Australian computer software for property analysis uses monthly intervals, the study of completed real estate investments can be divided into annual periods. The tenancy schedules highlighting the monthly calendar of rent reviews and lease expirations are conveniently linked to this.

According to the financial convention, all income receivable during the term is treated as if received at the end. However, most computer programmes and Australian standards treat every amount received throughout each period as if received at the start.


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Step 3 - The initial payment

The monetary outflow incurred while purchasing an income-producing property is the initial outlay.

The initial outlay typically consists of the purchase price, any necessary initial repairs or modifications to make the property tenable, and the acquisition fees (including stamp duty), less any borrowed funds, net of any loan establishment costs. 

The initial outlay calculation for residential property is as follows -

Initial Outlay Calculation

Initial Outlay Calculation

It may be required to precisely calculate the acquisition expenses later if they are first calculated as a proportion of the purchase price.

Each State has its own stamp duty system, which is progressive and has a varied percentage of the purchase price depending on the price. 

Most States utilize settlement agents for straightforward property transfers, and they often collect fees based on a published scale in addition to ancillary fees or "disbursements."

Buying a rental home may also include additional expenses like building inspection fees. Engineers and other experts, such as land surveyors or tax experts, may be hired to purchase medium-sized or big commercial buildings. Their costs could total up to 1% of the purchase price.

Often referred to as "period 0" (zero) of the cash flow, the initial outlay is an outflow at the beginning of the first period of the cash flow analysis.

Step 4 - The equity cash flow before taxes 

Net (rental) income less loan payments equals equity cash flow before taxes.

The rent due less necessary vacancy allowance and any expenses the landlord must pay for the property determines the net revenue from the property for each year of the intended holding period. 

The recent history of vacancies and bad debts for the property and the anticipated market conditions during the holding period will determine the vacancy allowance or factor. 

Many contracts allow the landlord to deduct "net rent" from the tenant(s) and part or all construction expenses and income taxes. It is crucial that the net income accurately reflects the landlord's rental income following the deduction of all recurring statutory charges and operating costs.

To calculate the "property cash flows before tax," any capital costs required during the holding term should be subtracted from (or added to) the net income. When capital spending is neglected, cash flows are inflated because it is frequently necessary to keep a building appealing to tenants.

In most cases, the property cash flows before taxes and the net income are the same.

The loan interest and servicing charges are deducted from the net income. The loan terms are used to determine the payments. 

For loans that amortize, payments can be computed using spreadsheets, calculators, or financial formulas; however, for loans that are interest-only, payments are simply the interest rate per period multiplied by the loan amount. 

To calculate the equity cash flows before tax, subtract the loan service fees that may have been incurred throughout each period.

It may be more appropriate to use different growth rates for rentals and operating costs and to allow for growth rates that reflect altering market conditions in each period of the cash flow analysis to estimate the cash flows for future periods. 

Similarly, unless the investor plans to take out a fixed rate loan, each period's loan payments should account for the likelihood of interest rate adjustments. 

The table below calculates the equity cash flows for the residential property's first two years. 

The change in gross income (Row 2) estimates the second year's income based on a percentage growth rate applied to the gross income of the first year. The vacancy allowance (Row 4) subtracted from the gross revenue each year is calculated by multiplying the gross income by the vacancy percentage (Row 3). 

The change in property charges (Row 7) is a percentage growth rate applied to the first year's statutory charges (Row 5) and operating expenses (Row 6) to estimate the second year's property expenses. 

The net (rental) income is calculated by subtracting the vacancy allowance, statutory charges, and running costs from the gross income (Row 8).

Equity cash flow before tax calculation

Equity Cash Flow Before Tax

The interest-only loan payments for a year on a $398,000 mortgage at an annual interest rate of 8% come to $31,840. (Row 9). Loan payments and loan servicing costs (Row 10) are deducted from the net income to calculate the equity cash flow before taxes (Row 11).

The bottom row demonstrates that although the loss in the second year will be less severe, the equity cash flows for the first two years will be negative. The investor needs to find cash from other sources to cover a portion of the loan payments.

Step 5 - The taxable revenue

You can calculate the property's taxable income as the net income less any tax deductions for depreciation and other allowances, the interest component of mortgage installments, and an annual percentage of loan establishment fees. 

It depends on the assumption that all building expenses are tax-deductible. However, while they may appear as operating expenses in the owner's accounts and may be recouped from tenants, capital expenditures and funds placed in sinking funds to cover future liabilities are not tax-deductible. To determine the taxable income, they need to be adjusted.

The taxable income from the home unit in the ongoing example is calculated for the first two years in the table below. 

A $2,400 annual capital (or building) allowance is allowed for each holding period's five years. It is possible but laborious to calculate plant depreciation item by item for each period. 

For this example, it is assumed that the entire plant ($31,827) will have a practical life of 15 years. This will result in a deduction of $4,244 in the first year at the diminishing value rate of 13.33% pa and $3,678 in the second year.

The entire interest-only loan payment ($31,840 annually), as well as the loan service fee and a percentage of the loan establishment costs, are all tax deductible. Since only the interest is tax deductible, the interest component of amortizing loans must be distinguished from principal repayment.

Taxable Income

Taxable income

A negative taxable income (Row 16) indicates that the property's assessable income is less than the owner's tax deductions. Property tax loss decreases as rental income rises and plant depreciation deductions diminish.

Step 6 - The equity cash flow after tax

The income tax owed is subtracted from the equity cash flow before tax to arrive at the equity cash flow after tax for each year. The amount of income tax due is typically calculated by multiplying the taxable income by the investor's marginal tax rate.

The marginal rate is the amount the investor would pay (or avoid paying) on any additional taxable income or tax losses the property generates.

The tax that will be due (or saved), assuming the investor pays taxes on a graduated basis as individuals do, will be the difference between the investor's tax burden with and without the property included in the annual tax return. 

Some of the more complex computer models do, in fact, more precisely determine the tax liability from real estate investments.

In this illustration, a marginal tax rate is used for an investor earning $80,000 a year. If most of this income is taxable, it will be subject to a tax rate of 30% (assuming). 

The investor will save tax at the rate of 31.5 per cent because the property is anticipated to result in tax losses (tax losses do not reduce taxable income below the threshold to pay tax at 30 cents in the dollar; this is added to the 1.5 per cent Medicare levy). 

After deducting the tax due (Row 17) from the equity cash flow before tax, the after-tax equity cash flow (Row 18) for the first two years is displayed in the table below (Row 11).

Equity cash flow After tax

Equity cash flow after tax

This tax loss may lower the owner's other taxable income in that year if the taxable income is negative. However, the tax loss is carried forward and might lower taxable income in subsequent years if the owner does not have enough taxable income that year. 

Analysis of after-tax cash flows often assumes that investors have enough additional taxable income to take advantage of the tax losses produced by the asset. 

The cash flow before taxes is therefore increased if the tax payable is negative. When it comes to this property's financial losses before taxes, the tax that was saved offsets them. 

For instance, in the first year, the equity cash flow after tax is a smaller negative sum of -$4,447, while the equity before tax cash flow is negative -$9,656. 

It exemplifies how losses are minimized if they are tax deductible. A negative cash flow can turn into positive cash flow after taxes with significant depreciation deductions.

The process for computing the period-by-period or "interim" after-tax equity cash flows is summarized in the diagram below.

Step 7 - The resale proceeds

The investor presumes to sell the property and settle any outstanding debt and taxes on capital gains within the analysis's final term. 

The final intermediate cash flow includes the resale proceeds. The resale proceeds are the expected selling price less the costs of sale, the outstanding loan, any fees to pay off the loan, and any capital gains tax.

You can calculate the resale price by multiplying the current price or value by a growth factor; typically, the compound growth rate during the holding term is used. The alternative is to calculate the resale price by dividing the anticipated net income in the year following the sale by a resale yield.

The justification for applying a permanent yield to future net income is that, first, many Australian investors still use the initial yield to assess income-producing properties. Second, it is frequently unjustified to further examine income for years in the future.

This strategy also assures that the income growth and the capital value increase are consistent.

In reality, the resale price is estimated using the net income immediately following the sale because this is the revenue that a buyer would consider. The net income following the sales and the "reversions" at that time is "capitalized" by some computer software for discounted cash flow analysis of commercial assets.

Interim after tax cash flows

Interim after tax cash flows

The selling expenses, which include transfer and real estate agent commissions, lower the resale price. A percentage of the resale price is typically used to express the selling costs. The percentage of selling price taken up by these fees is smaller at higher prices and would be slightly variable in each State due to the real estate agent's commissions being on a sliding scale. 

While selling for $250,000, the resale expenses would be around 4%; selling for $1,000,000 would be around 2%.

The remaining loan sum and any fees associated with paying off the loan are subtracted. The loan's terms determine the prepayment penalty in full. The taxable income in the year of the sale would be decreased by these fees, which are tax deductible. 

In this case, the $398,000 that was borrowed is the remaining balance of the interest-only loan. Any fees are disregarded as the five-year interest-only loan would be coming to an end. They would be small costs, like deleting the charge from the title.

Resale proceed after tax calculation

Resale proceeds after tax calculation

The resale proceeds after tax are calculated by estimating and subtracting any expected capital gains that would be taxable from the selling price. 

The after-tax interim cash flow from the final year of the holding period is combined with the after-tax resale proceeds to display the after-tax equity cash flows in the timeline.

Resale proceeds after tax cash flow

Resale proceeds after tax

Most private investors are eager to maximize their tax benefits and take on significant debt to purchase real estate properties. These investors can utilize the equity cash flows after taxes to inform their choices for whether to buy the property, how much to pay and how much debt they should take on.

Step 8 - The property's after tax cash flow 

Private investors are less likely to compute these than tax-paying businesses and property funds. These businesses and funds with the weighted average cost of capital after taxes can utilize the property cash flows.

The property's after-tax cash flow is determined as the property's pre-tax cash flows less the tax obligation as if the property had been purchased outright. The initial investment is equal to the purchase price and the acquisition costs. 

When there are no loan-related tax deductions, the interim property cash flows after taxes equal the property cash flows before taxes minus the tax liability. The property before tax cash flow is the net rental revenue if no capital investment is anticipated over the five-year holding term.

The net rental income less the depreciation allowances, ignoring any tax deductions for the loan, is the taxable income. Taxable income is multiplied by the marginal tax rate of 31.5 per cent to determine the amount of tax due. The net income less the tax due makes up the intermediate property after tax cash flow.

Although the equity after tax cash flow is the focus of this article, there are times when another cash flow is more crucial to the property investment analysis. Therefore, calculating these tax cash flows for each potential purchase is advantageous and involves minimal work.


What is after tax cash flow?

After tax cash flow is the net cash flow of a company after taxes have been paid. This metric is used to measure a company's profitability and is a key drivers); for many financial decisions made by investors and management. After tax cash flow can be positive or negative, and is typically expressed as a dollar amount.

Is after tax cash flow the same as free cash flow?

Cash flow is the movement of cash in and out of a company. After-tax cash flow (ATCF) is the amount of cash generated by a company's operations, minus the amount of tax paid on that income. Free cash flow (FCF) is the amount of cash left over after a company has paid for all its operating expenses and capital expenditures.

In short, ATCF = FCF - Taxes.

What are the 3 types of cash flows?

The three types of cash flows are operating cash flow, investing cash flow, and financing cash flow.

Operating cash flow is the amount of cash generated by a company's normal business operations. It includes revenue from sales of goods and services, less the cost of goods and services sold. Investing cash flow is the amount of cash used to acquire or divest long-term assets such as property, plant, and equipment. Financing cash flow is the amount of cash generated or used by a company to finance its operations, such as through issuing debt or issuing stock.

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