Think back to the first time you got coaching on what to pull from a tax return. I’ll bet somewhere in that conversation you heard:
“Add back depreciation.”
We add back depreciation when pulling cashflow from financial statements, too.
Depreciation is a non-cash, calculated expense. It is totally appropriate on financial statements and tax returns, but does not represent an outlay of cash.
We add it back because, when interested in cash outlays, what they are paying in cash is more helpful. And for most significant purchases of equipment or buildings, the cashflow is representated by loan payments.
If you counted loan payments against them…and counted depreciation against them…you’d hit them twice for the same thing.
Here are other noncash items that can make taxable income so very different than cashflow available to pay debt (and family living expenses if a personal loan):
- IRA Rollovers…If the first trustee sent it to the taxpayer instead of the next trustee, a 1099 will be filed and the income must be reported. Taxable will be $-0-, though, if they rolled it in time.
- Conversion from traditional IRA to Roth IRA
- K-1 income/gain reported on the owner return but received by a pass-through entity filing an 1120S or 1065
- Depreciation…Bookkeeping write-off of tangible items
- Amortization…Bookkeeping write-off of intangible items
- Depletion…Bookkeeping write-off of natural resources
- Carryovers…Expenses or losses from a prior period that could not be used due to an IRS rule or limit, but can be carried into the current year
- Net Operating Losses…A loss related to business (generally) from a prior year that was limited but can be carried forward
- K-1 pass-through expenses or losses…Amounts an individual owner of an S Corporation, Partnership or LLC (filing a 1065) must include in income/gain or can take as an expense/loss even though s/he did not actually receive or pay it. Companies filing an 1120S or a 1065 pass-through their income, deductions and credits to their owners. (See the owner’s K-1 to see what they actually received or spent).
- Some long-term capital losses…If the capital asset (such as stock) was purchased in a prior year, a capital loss for tax purposes may ‘camoflauge’ a real, and significant cash inflow from the sale.
What you do with noncash items depends on whether they have ‘hit your numbers’ yet.
If a noncash income/gain item is already in a total you are using (like AGI), subtract it back out. If it is not in your total don’t add it.
If a noncash expense/loss item is already in a total you are using, add it back. If not, leave it alone.
Have you seen my tutorial on Green Legos, Six Ns and a Map to Tax Return Analysis yet? If you find these blog posts are on the 6 Steps from Taxable Income to Cashflow a stretch, try the tutorial and all will be made clear!