Sometimes I’m guilty of throwing around yield numbers on this blog without providing specifics. I’ll say “we legged into a 9% un-levered yield” or “the cash-on-cash yield on this deal is 6%”.
Some of you are probably sitting there thinking that you can compare those yields with, for example, what you can get by lending money on Lending Club or buying treasury bills or whatever.
Those aren’t apples to apples comparisons, but those aren’t apples to apples comparisons, because they don’t take into account the tax treatment of the cashflow coming in.
To start, you need to understand that interest income of any type is taxed at normal interest rates. That means, for someone in the highest marginal tax bracket, making a loan to someone at 8% nets you something like 4% / year post tax.
Rental income is also taxed at normal income tax rates, with one big difference: You get to take advantage of depreciation.
Consider the following example of an 8% yield deal:
- Buy a property for $1MM cash
- Collect net operating income (rents less all operating expenses, including property tax) of $80,000 / year
- That’s an 8% yield ($80k / 1MM = 8%)
- But we’re not done…
- Assume of the original $1MM price, 50% of the value attributable to the structure (eg not the land)
- Depreciate the $500k structure straight-line through 27.5 years, implying 18,182 of annual depreciation
- To calculate the after tax yield, deduct the depreciation from the NOI…$80k – 18k = $62k
- Pay 50% tax on $62k, leaving $31k after tax PLUS the $18k that was sheltered by depreciation
- Total post tax cash of $31k + 18k = $49k
- $49k / $1MM = 4.9% after-tax yield
So, two different investments, each boasting an 8% yield. But one gets you 4% after taxes and one gets you nearly 5%.
If you don’t think that’s a big deal, then I invite you to mail me an annual check equal to 1% of your post-tax income from investments.