Cash Flow from Depreciation™

Cash Flow from Depreciation™ is your gross depreciation for a property times your estimated tax rate. It gives you approximately how much money you expect to receive from a rental property in tax benefits.

Because it is a variation of cash flow, we tend to think of it in terms of a monthly amount. Although, for the Return Quadrants™ we will present it as a yearly amount.

For the Return Quadrants™, we show it in this section:

Over Time

Gross depreciation is established when you buy the property. For residential properties, it remains the same for 27.5 years.

And, unless your tax rate changes, your Cash Flow from Depreciation™ will stay the same over that same 27.5 year period. If your tax rate changes the actual amount you’re receive in Cash Flow from Depreciation™ will change over time.

Once you no longer qualify to take depreciation from a property (after 27.5 years for residential, 39 years for commercial), the Cash Flow from Depreciation™ will also go to zero.

This, combined with paying off a mortgage, is why the returns from real estate eventually will consist of just unleveraged appreciation and cap rate.

You can see this in this Chart showing the four areas of return on equity (appreciation, cash flow, debt paydown and Cash Flow from Depreciation™) from Andrea in Episode 1.

Ep 1 - Andrea - Return on Equity with Cash Flow from Depreciation - Stacked — Ep 1 – Andrea – Return on Equity with Cash Flow from Depreciation – Stacked

If you tax rate increases the amount you receive from Cash Flow from Depreciation™ goes up as well since the depreciation benefit impacts your top tax bracket first. This is one tax benefit that helps more as your income goes up.

Since the dollar amount of gross depreciation is fixed over the full 27.5 years and the other areas of return (appreciation, cash flow and debt paydown) tend to increase over time, the return from Cash Flow from Depreciation™ tends to be most significant early on in the investment. As the investment ages and the return in dollars from the other areas of return tend to go up, Cash Flow from Depreciation™ tends to be a smaller percentage of the overall return you’re receiving. That is to say it becomes less significant.

Depreciation Recapture Tax

It is true that the depreciation benefits you take on rental property are taxed later in the form a depreciation recapture tax.

You cannot choose not to take depreciation to avoid having to pay the tax back later so you might as well take it and enjoy it while you get it.

Depreciation recapture taxes are typically paid when you sell a property. They are typically the lower of your then current tax rate or 25%. We discuss this in more detail when we talk about calculating True Net Equity™ (or what you’d walk away with if you sold your rental property after all expenses including sales costs, transaction costs, capital gains and depreciation recapture taxes).

Of course, you can DELAY having to pay depreciation recapture taxes by not selling the property or by using a 1031 tax deferred exchange. A 1031 tax deferred exchange does not eliminate depreciation recapture taxes, it just pushes them off to a later date when you sell the replacement property. See Should I Sell My Rental Property? for a more thorough discussion of selling your rentals.

If you die, your heirs will receive the property with a stepped up basis essentially resetting the depreciation recapture tax bill.

Pulling out equity with a cash out refinance does not trigger depreciation recapture taxes either. See Should I Refinance My Rental Property? for more info on that as well.

True Cash Flow™

When calculating True Cash Flow™, we use regular cash flow and Cash Flow from Depreciation™.

True Cash Flow™ = Cash Flow + Cash Flow from Depreciation™

Receiving Cash Flow from Depreciation™

Some real estate investors believe that since Cash Flow from Depreciation™ is a depreciation benefit that you only receive it at the end of the year on your tax return. It is true that’s where it is “accounted for”, but you can choose to “take” these tax benefits in one of two ways.

First, you can choose to take them through a larger refund at the end of the year, paying in less taxes at the end of the year or, by adjusting your exemptions on your paycheck, monthly as extra money in your monthly paycheck from your job.

When you adjust your exemptions, you’re saying… don’t take as much tax out of my monthly paycheck from my job because I know that I am going to get this depreciation benefit at the end of the year. Instead of getting a lump sum back at the end of the year (or having to pay a lump sum less if you did not pay in as much as you should have), you choose to get more from your paycheck each month.

This can be used to improve cash flow or to reduce negative cash flow especially when buying in negative cash flow markets or with low down payments like when using the Nomad™ real estate investing strategy.