One of the most lucrative markets in the world is real estate. At the same time, it is the most complicated. Within the housing market of any country, you will have an enormous amount of speculations which makes it hard to discern a proper investment. And if you are in the business long enough, you will understand that to make any substantial amount of wealth, you will need to invest in a multitude of properties. Which entails a lot of speculation of fixed assets that need proper number crunching. This is why accounting is critical to any real estate business.
It’s easy to think of accounting as a backroom chore, a tedious task that only serves to protect you from the IRS. In actuality, good accounting is your ticket to better financial decision-making, increased cash flow, and improved asset management.
But First Real Estate Accounting Regulations
The federal government mandates that private companies follow specified standard accounting practices. The purpose of these accounting regulations is to:
The Financial Standards Board (FASB) is the authoritative nonprofit organization that sets accounting standards. FASB has been designated by the Securities and Exchange Commission (SEC) as the official standard for accounting practices of the United States. To understand more of their standards click here: FASB website
Following all these regulations and honestly make a mistake in your accounting practices, can still get you into serious problems. But it is considered a serious white-collar crime to intentionally manipulate financial information and may warrant prosecution. A very serious warning here for those interested in doing real estate business.
There are so many important regulations you need to be aware of and it’s quite overwhelming at times. The enormous amount of rules and regulations within American accounting needs to be seriously understood.
Maybe you’re reading this guide because you might be able to do the accounting yourself. But remember, keeping records and managing the transactions is a task that never ends and could seriously harm your company’s financial standing and hurt your relations with your shareholders.
A friendly piece of advice – hire a CPA and incorporate specifically tailored software for real estate business accounting and management. Accountants are trained in the business of bookkeeping (they often spend years in school studying the ins and outs), and they have sufficient know-how to perform accounting work faster and more accurately than you can. And use software that was built by professional accountants that are specifically tailored for real estate business like Beaver software. (zero hard sell here btw)
Still not convinced? That’s all right. We’ll try and convince you several more times throughout this guide.
People that Request for Accounting Records
- Government entities
While financial reports are made to the IRS during tax season, the IRS may request more detailed financial records if your company is selected for audit.
Should you hire an accountant?
The answer is always yes! Because alone, you can’t file your tax returns at the year-end. Tax accounting is a bit different from regular accounting. You can’t do this on your own. Hiring a good CPA will make a significant difference in the tax payments. So yes, you should always hire a CPA.
However, for monthly bookkeeping, it is a different story. I highly recommend you do it yourself. A software like Beaver can reduce the amount of your work significantly and if you are lucky, your bookkeeping and reporting can be taken care of by the software entirely.
Even with excel, if you learn the basics which I will explain below, you can totally do bookkeeping by yourself.
The best solution is to do your monthly bookkeeping by yourself and ask your CPA to review your book at the end of the year and file your tax return. But I do recommend using software specifically tailored for the complex nature of managing a real estate business.
Bookkeeping is basically all of your company’s financial transactions being recorded The foundation of good real estate accounting is accurate and property bookkeeping.
Cash Basis or Accrual Basis?
In accounting, you will need to pay attention to two types of basis to do proper bookkeeping.
Cash Basis: This means that you book your transactions based on the date that cash was transacted. If you receive rental income on 9/30, you record it on 9/30. If your payment for a plumber is transacted on 10/1, you record it on 10/1. This is much easier and in most cases, you can just bookkeep on a cash basis yourself and should ask your CPA only for some complicated transactions.
Accrual Basis: This is the method of recording accounting transactions for revenue when earned and expenses when incurred. But this can be complicated because, to perfectly bookkeep transactions, you have to be proficient in the relevant accounting principles.
Accounts payable management is critical to managing a business’s cash flow. And to help prevent business fraud from within your organization, it’s important that you establish separation of duties and internal controls within your AP process.
For example, if you receive an invoice for your expense on 9/30, and the service for the plumbing is already made on 9/30 but you made the payment on 10/1, you should record the invoice amount as “Accounts Payable” as of 9/30, and when you actually made the payment on 10/1, this way you will record the cash out to reduce the accounts payable. If you need to use a balance sheet for items such as accounts receivable or accounts payable, then you will have to use an accrual basis. If you have some items that have to be recorded on an accrual basis, you should definitely consult with your CPA.
Double-Entry Bookkeeping (Debit and Credit)
Get to know the double-entry bookkeeping system. This is a system of accounting in which each transaction results in two entries being made: a debit and a credit. These have nothing to do with debit cards or credit cards; we’ll refer to “debit” and “credit” by their accounting context:
Understand what a double-entry bookkeeping system is, your accountants will love you. This is a system in which every transaction is being made the result of having two entries that become debit and credit.
- Debit: When cash is obtained in a transaction (account is debited).
- Credit: When cash is spent in a transaction (account is credited).
Let’s pretend you have a business ledger in front of you and you collect a $1,000 rent from a tenant. Basically, you will record the transaction twice, $1,000 to the debited and $0 recorded as credited.
The benefit of this is to utilize the fundamental equation for proper accounting, known as the accounting equation within the Balance Sheet which I will explain further below.
The Balance Sheet
Real estate accounting follows the most fundamental accounting equation.
Assets ($200) = Liabilities ($100) + Equity ($100)
And there are 5 elements that affect all of your transactions within accounting.
You will be able to have complete control and understanding of your companies finances by understanding how each of these elements operates.
Assets refer to something the company owns and uses for the benefit of the company. So long as it can generate cash, it can be considered an asset. Under assets these three are important to know:
- Fixed asset: This means the property you bought or something of value that the company will own for a long time. Your will need need to calculate your adjusted basis. You can include some of the legal fees and transaction fees on there too.
- Current asset: These are assets that will eventually be converted to cash quickly.
- Depreciation: This is the reduction in the value of an asset with time. If you purchased a property for an investment, you can depreciate. You can even reduce your taxable income by the yearly depreciation. Click for more details here.
Liabilities usually include mortgages you required to purchase the property and interests payable that you have to pay periodically.
- Mortgage payable: The funds you have received from your lender which you will keep paying into the principal until you paid off.
- Interest payable: This is the interest expense that you have been charged but have not made payments for yet.
Equity usually consists of (1) the funds you injected when you created the company and (2) retained earnings or losses, you have accumulated over the years. Net income from the income statement, which is explained below, is also part of Equity.
- Owner’s equity: This is a fixed asset which in this case is the property you bought. You will need to calculate your adjusted basis. You can include the legal and transaction fees on an adjusted basis.
- Retained earnings/loss: The accumulated amount of net income or loss over the years since the company was incorporated.
- Net income/loss: This is the main reason why you buy property. If your property is for investment, you can reduce your taxable income by the yearly depreciation. Here is for mode details.
The total amounts of Assets “MUST” equal the total amount of Liabilities and Equity. This is why it is called the Balance Sheet.
The Income Statement
The income statement or Profit and Loss Statement (PL) will have different sections which are the:
- Rent income: This is the rental income your receive from your tenants.
- Capital gain: This is what you have gained in terms of fair market value since the purchase of the property.
- Property tax: The municipality would send you a tax statement every six months or annually. This tax is based on the assessed value decided by the relevant municipality. If you think it might be too high, you can reduce the property tax by making an appeal to the municipal of where the property is located.
- Property management fee: This is an expense you pay if you hire a property manager to manage your property. They usually charge you monthly.
- Professional fees: These are fees such as lawyer and accountant fees. For example, paying a CPA to file a tax return is a fee recorded as a professional fee expense.
- Repair and maintenance: These are fees such as a plumber or electrician that comes to do maintenance or repair on your property. Another example would be the monthly cleaning expense.
- Utility: These are gas, electricity, and water bills. Internet and phone bills are not considered utility.
- Capital loss: How much you have lost in terms of fair market value since you bought the property.
Manage Documents: Keep every single invoice or statement
The most important thing to remember as an investor is to keep every single document regarding your real estate business operations. It is critical to keep every single one, by doing so your CPA will be able to verify your transactions which will be necessary during tax filing.
And when you get audited by the IRS or State, then you can feel safe that you have all the evidence needed. In some cases, you will have to keep it for 7 years. Here are more details for IRS standards.
Manage Bank Account
Another important practice that many real estate investors and property managers have trouble doing is to manage the business’s bank accounts well.
If you are an individual real estate investor, you may use a personal bank account. But I highly recommend you separate your business bank accounts from your personal ones. This way your personal assets may avoid any legal issues.
Manage Rent Collection
All of the rent being deposited into your bank account should be categorized as rent income. But if you want to perform some analysis such as which tenants are paying on time, then it is always better to record rent payment on a separate document. Usually, people call it “Rent roll”. Rent roll is not directly a part of accounting but it can be an important measurement for other factors when comes time to selling or buying a property.
Rent roll should contain information such as :
- Rent amount
- Rent due date
- Rent paid date
- Rent paid amount (Sometimes tenant pays only partial)
- Property name
- Unit name/number
- Tenant name
If this information is accurate, you can perform various kinds of future analytics such as what type of tenants pay on time from those that don’t. It is always better to manage rent roll tenant by tenant or unit by unit. It could be tedious to do but it is critical if you plan to sell your property in the future. Because if you do not have accurate numbers, it will significantly delay the closing of any future deals.
Manage Expenses Account
Just like with rent collection, it is better to manage your expenses unit by unit. Especially those with multiple units. Like rent roll, having this record will definitely help you negotiate your deals when you sell those properties. These are the criteria you need to record as you manage your expenses in the real estate business.
- Vendor name
- Vendor’s profile such as email address, physical address, phone number, etc
- Description for the expense
- Invoice date
- Paid date
- Invoiced Amount
- Memo (Believe it or not, a little note for yourself what you did with this vendor or some situations when this invoice was issued or paid will help you a lot later.)
- Allocating data to relevant property or unit
The last one is very important because this will allow you to perform a much-needed future analysis. For example, if you pay $1,000 for one vendor that did some work for 3 different properties, it is up to you to break down and record the amount into each relevant property. Doing so will help you significantly later when comes time to sell the property. I suggest using automated software to help you perform these tasks since doing them manually is tedious work.
There are many types of reporting formats in the real estate business. Property managers will prepare monthly property reports which show cash inflow and outflow. Financial Reporting most likely includes a “Balance Sheet” and “Income Statement (Profit and Loss Statement)”. Which make the most important financial documents that you have to prepare at least once a year for your tax return.
A Balance Sheet is basically a snapshot of your financial situation. Every year it carries over whatever your gain or loss is onto the next year after the fiscal year-end. This shows how much you have as an asset and liability. If liability is significantly large compared to assets, your seller may not be interested. The balance sheet shows the accumulated financial impact on retained earnings if the property has been making money or losing money.
The income statement basically shows how much you are earning or losing of that period (Month, Quarter, Year). It is obviously the most important financial statement you need to evaluate for your investment.
One time expense
Sometimes real estate business requires some one-time large payment for water leaking, cutting down some large trees, or purchasing some appliances. These types of one-time payments are not recurring expenses so you should be careful when you evaluate.
Recurring expenses such as property management fee, utility, broker fee, etc are very important factors when you evaluate your investment. You should carefully examine and perform due diligence if those expenses are accurate and possible to reduce if you buy that house.
Using a Balance Sheet and Income Statement can calculate the most important number that every real estate professional uses to determine an asset’s possible value. That is the Capitalization Rate (Cap Rate)
- Equation: Property Value / Net Operating Income = Capitalization rate
When you sell or buy a property, you will negotiate the cap rate. If you do not have a proper understanding of real estate accounting that helps you understand the Cap rate of your property or a property you want to buy, then how will you be able to know this investment is right for you?
Put simply, the cap rate measures a property’s yield in a one-year time frame. This makes it easy to compare one property’s cash flow to another – without taking into account any debt on the asset. In short, it provides the property’s natural, unlevered rate of return.
What If I Fall Behind?
You might have to wear many different hats when running a small real estate business due to a lack of manpower. But doing so can easily make you fall behind in bookkeeping and the management of the property. Especially given that every single real estate transaction incurs several small costs and fees.
Therefore you need to have trustworthy accountants. But most importantly, having the right software like Beaver that can help automate these tasks in bookkeeping and management will do wonders for you. Specifically for those owning multiple properties.
Real Estate Accounting in a Nutshell
Accounting covers a broad range of facets and tracks an overwhelming amount of financial numbers (which you’re no doubt aware of since you’ve reached the end of this guide). If you run a small business or if you enjoy challenging yourself to such laborious tasks, you might be tempted to do all of your accounting on your own.
Again—and for the last time, we promise—we recommend enlisting the services of an accounting company and using the proper software. Accounting is a massive and massively important business endeavor. It’s all too easy to get behind on the books or to record inaccurate information—and don’t forget that your business may face severe financial penalties if you do.
If your business is involved in the real estate trade in any way, you could benefit tremendously from having an accountant that’s knowledgeable about the housing market. Some of those trades include:
- Real estate brokerage
- Real estate developer
- Property management
- Building construction
- Real estate investing
- Housing association
For any business involved in these, the right software and accountant can help to:
- Prepare accurate tax filings
- Find places to cut costs
- Evaluate the profitability of assets
- Prepare for market changes (for example, a seller’s market becoming a buyer’s market)
If possible, hire the right CPA and use professional software that can manage both aspects of accounting and property management. Software like Beaver will shoulder nearly all of the accounting and management workload for you an all-in-one software. That way, you can spend less time bookkeeping and managing your property, and more time finding and selling properties.