You inherit a haunted house from a long-lost uncle you didn't know you had. You decide to rent it out to earn a little cash. Other similar homes in that area are renting for $2,500 a month. So that means your annual income from the property will be $30,000, right? After all, that's $2,500 a month times 12 months in a year...gives you $30,000 a year.
Kind of. That figure is called your gross potential income. It's the hypothetical total you'd receive if everything goes perfectly. But everything rarely goes perfectly. Thus, effective gross income becomes a more realistic figure.
You can start with gross potential income, but the "effective" part becomes key in a real-life scenario. There are other factors to take into account.
Some of these are good. A property can generate other income besides rent. Your uncle's house has a coin-operated washing machine in the basement and pay toilets in all the bathrooms. Extra money for you. Those figures get added in when you calculate the effective gross income.
However, some factors take away from the final total. For instance, you might have a hard time finding a tenant. It's a haunted house, after all (and one with pay toilets). Having the house vacant while you look for a renter will take away from your income.
Similarly, you have to take into account the fact that some renters don't always pay on time, or at all. If they don't, that cuts into your income as well.
Effective gross income takes this into account. Start with your gross income, add in the additional income, and subtract for the vacancy and credit allowances. It gives you a more realistic figure about what to expect in terms of annual income.
Related or Semi-related Video
Finance: What's the Difference Between F...145 Views
Finance, a la Shmoop. [title page] What's the difference between federal
and state taxes? All right, well, when the U.S. came together a quarter of a
millennium ago, it was the United States. See, right there in the title you get a [founding fathers pictured]
sense of the tension. We started out as just states. These things. Then, we came together [individual states on map]
and created a central government that kind of sort of had control over each of [government tries to control states]
the states, and well, you can imagine that not everyone agreed about every rule.
Some states wanted murder to be an offense punishable by death, while other [protesters picket]
states wanted it to be, you know, legal. Well, okay maybe not legal, but they
had different ideas about how you should deal with murderers... i.e., not all of them [person pushed into lion pit]
should be thrown into the lion pit. Anyway, this was all well and good when it just
involved local laws and customs. Local customs dictated local laws, and then
local taxes could be allocated accordingly. So they could pay for things [local laws and taxes diagram]
like a bouncy house for the mayor. But what happened when there was a threat of [mayor in bounce house]
military invasion? Well, what if Georgia wanted to fight
them commies, but North Carolina didn't? Yeah, that didn't work out so well. So [states argue over military]
for some things, there has to be a federal law that supersedes state law
and federal taxes that support those laws, like military spending. If only those [federal laws and taxes diagram]
pacifists in Maryland didn't want to spend money on guns, well, then what would
the rest of the country do? Yep, let Maryland start speaking Russian or [Maryland hippies hang out]
Chinese as the preferred language while the rest of the nation just watched [Maryland conquered]
while sipping their tea? Or in the United States' case, you know, eating doughnuts? Yeah. [Americans eat doughnuts]
So, military spending protects the entire country, and those expenses come out of [military budget chart]
federal taxes. National highways? Federal. Border Patrol? Federal. Space travel? [federal and local laws/taxes demonstrated]
Federal. Schools? State. Libraries? State. Little country roads? State... local.
You know... Or even smaller in the form of county
taxes as we get littler and littler... yeah. So federal taxes pay for all the big
stuff--the things that we share as unified Americans no matter what state
we live in, while state taxes pay for stuff particular interest to our little
local state, wherever it is. You know, like DC taxes aren't going to be used to
build a fire department in Minnesota. Stuff like that. [fire department in Minnesota]
Besides, Washington has their, you know, own fires to put out. [newscaster speaks]
Up Next
Why do taxes exist? Without taxes, Uncle Sam wouldn't be able to boss us around via the IRS, which uses taxpayer money to run the government. Those...
What are the types of income tax? Federal income tax. State income tax. Real estate tax. Value Added Tax (VAT). Some tax is progressive, some tax i...
What is the difference between progressive and regressive taxes (flat tax vs. marginal tax)? In the most basic sense, progressive taxes affect the...