Cash on Cash Return vs. Internal Rate of Return

At a Meetup the other night with other like-minded real estate investors, we got to talking returns on investment. Sometimes, we get to talking in jargon and sometimes we forget that everyone doesn’t have all of the definitions down pat, or they may have forgotten them entirely. I was going to re-create an article addressing the question of cash-on-cash returns vs. internal rate of return (IRR), but why do that when James Miller did such an outstanding job making this complicated topic easy to understand? Enjoy!

Real Estate Go Zone

Cash on Cash Return vs. Internal Rate of Return
by James Miller

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Cash on Cash
Cash in Cash return, or Return on Investment (ROI)  is the easiest Rate of return to calculate. It is also the one I use the most often as it tells me what the money is generating with regard to actual cash I can put in my pocket today.

To calculate it you take the amount you are getting from an investment, typically on an annual basis,  and divide it by the amount you have invested. Multiply this number By 100 and you have a percentage representing Cash on Cash Return.

For example if I have $10,000 in a property that is netting $100 per month, I am getting $1200 per year on my $10,000.

I divide the $1200 by $10,000 to get .12   I multiply this number by 100 to get my percentage of…

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The Missing Pieces

I was on the phone the other day speaking with a tax strategist. Not a CPA (well, he is a CPA, but not for the purposes of this call), not a bookkeeper, not a tax preparer, but a tax strategist. Just one more professional that I have found a need for moving forward. Why? Well, that’s for another discussion. I want to focus on what this tax strategist said to me that struck a chord. It might strike a chord with you too.

Opening our discussion, we initially spoke about being a full-time W-2 worker and what kinds of tax limitations that presents. That’s when the pearl of wisdom erupted from this tax strategist as he drew a very simple analogy.

“Remember when we were kids and we played with those gigantic 4 or 5-piece puzzles?”, he asked. I answered in the affirmative when he said that tax strategy is just like those gigantic puzzles. In order to complete the puzzle, we need all of the puzzle pieces. The puzzle will just not fit if we don’t have all of the pieces. That seemed logical and easy understand. Then, like a ton of bricks, he said that in order to make ANY tax strategy work, you must have all of the puzzle pieces. The important thing here is that as a W-2 worker, you don’t have all of the tax strategy puzzle pieces!

As a W-2 employee, even with a mortgage on your primary residence, you don’t have all of the pieces. He went on to say that the two important pieces that are missing in this scenario are a business and/or a real estate investment. Without those two critical pieces of our tax strategy puzzle, we will not have a satisfactory tax strategy. For it is the business owner and the real estate investor that have the ability to write off even the most mundane expenses. It is the real estate investor that has the ability to take depreciation. As a W-2 employee, you can’t do those things very well.

Each of these incentives even make sense from a government policy standpoint, right? The government wants you to start a business. The government is happy when you invest in real estate, so they “help” you do that with tax policy and incentives. So if you want to minimize your tax burden and formulate a better tax strategy moving forward, remember that starting a business and investing in real estate (and especially commercial real estate) are your missing pieces.