Pre-tax cash flow

Tax liability

After-tax cash flow

Investment performance


Income properties are those which are held primarily for the generation of income. In addition to commercial and investment properties such as office buildings, this category includes residential rental properties. An important difference between income and non-income properties is that deductions for depreciation are allowed on income properties. Income properties, like non-income properties, generate a gain (or loss) on sale, and they also create an annual income stream. The annual income streams are determined on both a pre-tax and after-tax basis in order to determine the productivity of the investment.

Pre-tax cash flow        

Cash flow is the difference between the amount of actual cash flowing into the investment as revenue and out of the investment for expenses, debt service, and all other items. Cash flow concerns cash items only, and therefore excludes depreciation, which is not a cash expense Pre-tax cash flow, or cash flow before taxation, is calculated as follows:


potential rental income

– vacancy and collection loss

= effective rental income

+ other income

= gross operating income (GOI)

– operating expenses

– reserves

= net operating income (NOI)

– debt service

= pre-tax cash flow


Potential rental income is the annual amount that would be realized if the property is fully leased or rented at the scheduled rate. Vacancy and collection loss is rental income lost because of vacancies or tenants’ failure to pay rent. Effective rental income is the potential income adjusted for these losses. To that is added any other income the property generates, such as from laundry or parking charges, to obtain gross operating income. Operating expenses paid by the landlord include such items as utilities and maintenance. These are deducted from gross operating income. Some owners also set aside a cash reserve each year to build up a fund for capital replacements in the future, for example, to replace a roof or a furnace. Cash reserves are not deductible for tax purposes until spent as deductible repairs or maintenance. The remainder is net operating income (NOI). When the annual amount paid for debt service, including principal and interest, is subtracted, the remainder is the pre-tax cash flow.

For instance, a small office building of 3,500 square feet rents at $20 per square foot. If fully rented, the annual rental income would be $70,000. Historically, the property averages $4,200 in vacancy and collection losses. Equipment rental will provide an additional $2,000 per year in income. The owner will have to pay operating expenses amounting to ten dollars per square foot, or $35,000 per year. The owner sets aside one dollar per square foot, or $3,500 per year, for reserves. The owner financed the purchase of the building with a loan that requires annual debt service in the amount of $20,000. The pre-tax cash flow for the building is illustrated in the following exhibit.

Tax liability                  

The owner’s tax liability on taxable income from the property is based on taxable income rather than cash flow. Taxable income and tax liability are calculated as follows:

Taxable income is net operating income minus all allowable deductions. Cost recovery expense is allowed as a deduction, while allowances for reserves and payments on loan principal payback are not allowed. Thus, since reserves were deducted from gross operating income to determine NOI, this amount must be added back in. As only the interest portion of debt service is deductible, the principal amount must be removed from the debt service payments and the interest expense deducted from NOI. Taxable income, multiplied by the owner’s marginal tax bracket, gives the tax liability.

Note on tax rate: when a rental property is owned as an individual or by way of a pass-through entity (partnership, LLC treated as a partnership for tax purposes, or S corporation), its net income is taxed at the individual’s personal marginal income tax rate.  The next exhibit shows the tax liability for the previous example using an individual rate of 24%.

Tax Liability 

net operating income (NOI) 29,300 

+ reserves 3,500 

– interest expense 10,000 

– cost recovery expense 22,000 

= taxable income 800 

x tax rate (24%) 

= tax liability 192 

After-tax cash flow After-tax cash flow is the amount of income from the property that actually goes into the owner’s pocket after income tax is paid. It is figured as: 

pre-tax cash flow 

– tax liability 

= after-tax cash flow 

The after-tax cash flow for the sample property is illustrated in the following exhibit.