Depreciation

Depreciation is the accounting and tax treatment that spreads the cost of an asset over its useful life. Residential rental buildings are depreciated over 27.5 years for US tax purposes, producing a deduction that shelters part of the cash flow from income tax. Cash on cash return is pre-tax and ignores it.

On a $250,000 property with $200,000 attributed to the building, annual depreciation is about $7,270. Against $4,756 of cash flow, the deduction more than covers the income for tax purposes, so the cash on cash return may be received with little or no current tax. Land is not depreciated.

An after-tax cash on cash return adds the tax saved to cash flow, which requires knowing your bracket and whether passive loss rules let you use the deduction. Depreciation is recaptured at sale, so it is a deferral more than a gift. Because it depends on the owner rather than the property, the standard cash on cash figure leaves it out and lets each investor add their own tax position.

Further reading: Depreciation on Wikipedia.