One of the many misconceptions of real estate investing is the belief that it is the annual cash flow of a rental property that federal and state incomes taxes are paid on each year. This is incorrect.
Annual cashflow and annual income subject to tax are two completely different things. Cashflow may feel like our income since it represents the money we put in our pockets each month but it doesn't take into consideration two very important differences.
To make things clear we should first define cashflow. Cashflow is simply the dollar difference between the checks written and income received each month. If your collected rents for a given month were $1500 and the checks you wrote for your mortgage payment, property management, utilities, repairs, insurance, etc. totaled $1200 for the month then you would have had $300 in positive cash flow for that month. Easy enough, but why isn't that also your taxable income?
The first place to look is that mortgage payment. Let's say that out of the $1200 worth of checks you wrote last month that $900 of it was your mortgage payment. If $800 of your payment was interest and the remaining $100 was repayment of principal then only $800 was truly an expense. The other $100 went towards your equity in the property and can't be counted as an expense on that investment. So now even though we put $300 in cash in our pocket for the month we really had $400 in taxable income. Ouch.
A second place to look would be personal property purchases for the rental. What if one month we purchased a new refrigerator for our rental and it cost $600. Obviously our cashflow got reduced by $600 (basically we just ate up two month's worth buying the fridge) but did our taxable income also get reduced $600? Unfortunately, no.
When we purchased the refrigerator we traded value. We didn't really have an expense. In essence we gave the appliance store $600 in value (the $600 in cash) and they, in turn, gave us $600 in value (the $600 fridge). Our net gain or loss was zero. Only by using the fridge and having time go by does the refrigerator begin to decrease in value. If you think of the fridge being worth $480 a year later due to use then you can see that at that point we laid out $600 a year ago and today the thing we purchased only has $480 in value. Our trade isn't even anymore and we lost (or expensed) $120 in value. This $120 expense is called depreciation and is explained more fully in our article on appliance depreciation.
By now we may be wondering if there is anything that goes the other way and makes our taxable income less than what we received in cashflow. The answer is "yes" and that thing is annual depreciation on the property itself.
Just like our refrigerator example the rental property itself is subject to annual depreciation. Unlike the refrigerator the property depreciates over 27.5 years instead of five years. A more thorough explanation of depreciation can be found on our depreciation basics page but for our example let's say the property is worth $150,000 and we can attribute $120,000 of that value to the structure (the house) and the remaining $30,000 to the land (the lot). In that case we get to write off as an expense on our property approximately $4400 (.036 x $120,000 - see IRS publication 946 table A-6 on page 74 or our depreciation calculator) each year. Using our original cashflow example of $300 per month we can see that even though we put $3600 in our pocket that year ($300 x 12) we actually report an $800 loss for the year! ($3600 minus $4400 in depreciation)!
All of this may sound complicated and that is certainly understandable. IRS 1040 Schedule E is really just the document that spells out all of these revenues and expenses for our annual taxes. It's almost like a spreadsheet in its form. It does need to be filled out properly, however, and that is EasyRentalTools' primary function. We've designed EasyRentalTools to take examples like the above and put them in a step by step fashion. The IRS also has instructions for Schedule E available for download.