Cash Flow and Capital Growth: What are they and how do they differ?
Whether investing in rental properties or commercial buildings, you’ll encounter a common query: Are you investing with the intent of securing cash flow or is your intent to accumulate capital growth? Generally, these are the two streams that are exercised when managing an investment property but how do they differ? First we must understand the meanings of each term. Cash Flow: The net amount of money being moved in and out of a business – whether that be in positive or negative amounts. The cash flow from an investment property would be the amount of money you have remaining after paying expenses and debts (i.e. mortgage payments). Capital Growth: The increase in value of an asset or investment over a specific time frame. Pertaining to investment properties, capital growth would mean the increased value of your property from the time of purchase to the time of sale. (This time frame is typically ten years when looking at an investment property.)
How do these terms relate when it comes to investment properties? Cash flow collected from a property is called passive income. Passive income is defined as income streams that are received on a periodic basis with little effort to maintain. Passive income is not only rental income, but royalties, dividends and pensions as well.1 Cash flow and principal payments are taxed at 50%.
How does cash flow compare with capital growth?
Striving for capital growth can save you from this tax burden. The tax on capital growth is deferred until the time of sale. The goal in a capital growth strategy is to reinvest the cash flow into the investment property. Re-investing in your property is a good idea because it allows you to classify renovations as capital improvements. Capital improvements are permanent structural changes that increases property value, extends property life or creates a new and beneficial use. The improvements could be new windows, flooring, plumbing etc. You do not pay tax on capital improvements. Increasing the value of property also allows you to charge a higher rent when a tenant vacates. However, this means you would require a supplemental stream of income to service your personal expenses.
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1https://www.superbrokers.ca/library/glossary/terms/passive_income.php