8. Income Tax Calculations

 
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Overview

Income tax is paid on rental income received during the holding period. It can be reduced by loan interest repayments as we'll find out in this lesson.

Lesson Notes

Company Income tax (Corporation tax)

- Income taxes are paid if the asset generates profits while in our ownership
- Income tax rates can vary by state, by asset and by investment duration
- Therefore, always consult your tax advisor when calculating your company's tax liability

Finding Taxable Income

- To calculate the amount of taxes paid, we must first calculate taxable income
Taxable income = Net Operating Income - [Interest Expense + Deprecation]
- Interest expense can be found from our mortgage calculations
- Depreciation is a complex accounting calculation
- Therefore, I've asked our client's accountants to recommend a depreciation estimate

Keyboard shortcuts

CTRL + C: Copy selected item(s)
SHIFT + →: Select next cell
ALT + E , S , F: Paste formulas
F4: Anchor cells

Transcript

Taxes can often be the most challenging part of a valuation model, because the amount paid can vary hugely depending on the jurisdiction, what investment vehicle you used to buy the asset and a number of other factors.

Taxes can be split into income taxes, which are charged on annual profits during the holding period, and capital gains taxes which are charged on the appreciation in value of the asset.

In most countries, capital gains taxes tend to be lower than income taxes.

When building a valuation model, always consult your tax advisor when calculating your tax liability, to make sure that your calculations are correct.

In this lesson, we're going to focus on income taxes.

To calculate income taxes, we'll need to go through a multi-step process.

We start with the net operating income, which we've already calculated, and we subtract our interest expense from our mortgage.

We then subtract our depreciation expense to get our taxable income.

We then simply multiply our taxable income by the income tax rate to find the income taxes paid each year.

This is a relatively simple method of calculating income taxes based on a US asset.

However, I cannot stress this enough, that you should always consult a tax advisor when making these calculations.

Let's now calculate our income taxes paid in Excel.

Underneath our mortgage calculations, I've included the relevant rows for calculating our income taxes.

I'll start by linking this cell to our net operating income which I calculated earlier.

And I'll copy and paste for the remaining cells.

I'll do the same for the interest expense which was calculated in the mortgage payments section.

And again I'll copy across for the remaining cells.

Now we need to find the depreciation expense.

Instead of trying to do this tricky calculation myself, I consult our client's accountants, who estimate that the depreciation expense in this asset will be around $25,000 per year.

I’ll add this value as an assumption in our dashboard.

And I’ll also add in a tax rate of 35%.

Returning to our financial model, I’ll add in these values for depreciation off camera.

If I now add up these three values, I'll get my taxable income.

So I'll write a SUM function and select these three cells.

And again I'll copy across for the remaining cells.

The marginal tax rate is simply equal to the income tax rate, so I'll enter the named cell and copy across for the remaining cells.

The income taxes paid are simply equal to the taxable income multiplied by the marginal tax rate.

However, if the taxable income is less than zero, we don't pay any income taxes.

For this calculation, I'm going to use the MAX function, which will return the maximum value of zero or the taxable income multiplied by the marginal tax rate.

And then I'll copy across for the remaining cells.

As you can see in the early years, we won't be paying any tax because the taxable income is negative.

However in the later years, as our net operating income grows, our income taxes will grow accordingly.

As I mentioned at the start of this lesson, you should always consult a tax advisor when making these calculations.

She will be aware of tax breaks that might apply for your particular asset, company structures to minimize your tax liability and other factors that can have a big impact on your annual cash flows.