If you do the math, you can see that this property has negative cash flow of $ 6,716 per year, or about $ 560 per month. Sounds brutal, doesn’t it?
If we assume that the investor does not demand any depreciation on the property, then taxes must also be paid on the net rental income. Known as the all-in cost of capital, depreciation can be used to bring your net rental income down to zero, but without causing a loss. However, when the property is sold, your previously claimed CCA is included in the income and is usually taxed at a high tax rate.
Although there is a loss in this example, the mortgage payments of $ 10,939 are non-tax deductible, so the property generates positive net rental income for tax purposes. The tax payable based on a 35% tax bracket (approximately $ 75,000 average income across the country) would be $ 1,478. This means the owner has a net cash flow expense of $ 8,194 for the first year of moving the rental property after taxes.
For this property to be cash flow neutral, an investor would have to make a down payment of approximately $ 220,000, or 44%. or after accounting for taxes and assuming no CCA, they would need about $ 275,000, or 55%.
Other financial considerations besides cash flow
Cash flow isn’t necessarily the best way to gauge the numbers, however. That’s how I would rate the property as an investment.
At a purchase price of $ 500,000, the property is actually $ 508,170, including land transfer tax and legal fees. If the property grows 3% to $ 515,000 after the first year and the $ 400,000 mortgage is repaid to $ 388,135, that translates to $ 126,865 net equity. The buyer invested $ 108,170 upfront ($ 100,000 plus land transfer tax and legal fees) plus an after-tax net cash flow loss of $ 8,194. This is a cumulative investment of $ 116,364 that is now worth $ 126,865 – a return of 9%. Of course, this return is only on paper, because the sale incurs transaction costs of 4% to 5% of the property’s value, turning the profit into a loss in no time.
What do the numbers look like after 10 years? At this point, the buyer’s accumulated investment is $ 188,555, including future annual cash flow deficits, which would result in net equity of $ 398,700 and a continued annualized deferred tax rate of return of 9%.
Over a period of 25 years, the annual return would decrease to around 7% due to the decreasing leverage and reduced mortgage interest deductions.