Best guide for basic real estate accounting

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What is real estate accounting and how is it different from regular accounting?

You wonder if “real estate” accounting is any different from regular accounting. The answer is. There is no particular difference. Real estate accounting is actually just the concentration of accounting. If you study accounting, you will also get to study real estate accounting as fixed asset is a significant part of accounting.

However, since real estate accounting is the concentration of accounting, there are particular accounts or topics you should study for such as fixed assets, how to calculate depreciation expense, property management expense, real estate broker commission, repair and maintenance, property tax and so forth which I will explain in a bit more details in this article.

Who should study real estate accounting?

  • Real estate investor
  • Real estate asset manager
  • Real estate property manager
  • Real estate broker
  • Real estate salesperson
  • Real estate accountant

Real estate accounting is not only for real estate accountant to study. Without proper understanding of real estate accounting, if you are an investor, how would you negotiate with your counter buyers or seller? How would you monitor if your asset manager or property manager is doing a good work. Real estate investors are very smart people. If you are a real estate broker or salesperson and have a good understanding of real estate accounting and you can explain the deals properly using the numbers, that would be a definitely a big plus.

Should you hire an accountant or do it yourself?

The answer is always YES because you can’t file your tax return at the year end. Tax accounting is different from regular accounting you learn at school. It is not easy to just study and file your tax return. Hiring a good CPA will make a significant difference on the tax payment so yes you do need to 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 explain below, you can totally do your bookkeeping by your self.

The best solution is to do your monthly bookkeeping by yourself and ask your CPA to review your book at the end of year and file your tax return.

Cash basis or accrual basis?

In accounting, there are two types of basis to bookkeep your book : Cash Basis and Accrual Basis.

Cash Basis : As you could imagine, cash basis means that you book your transactions based on the date that cash was transacted. If you receive rent 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 most of the cases, you can just bookkeep on cash basis. you should ask your CPA only for some complicated transactions.

Accrual Basis : Accrual basis can be complicated because in order to perfectly bookkeep transactions, you have to be proficient on the relevant accounting principles. For example, you receive an invoice for your expense on 9/30 and the service for the pluming 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, you record the cash out to reduce the accounts payable. If you need to use Balance Sheet items such as accounts receivable or accounts payable, you will have to use Accrual Basis. If you have some items that have to be recorded on accrual basis, you should definitely consult with your CPA.

Very basics of real estate accounting (Balance Sheet)

Real estate accounting follows the most fundamental accounting concept.

Assets ($200) = Liabilities ($100) + Equity ($100)

Assets are basically the properties you purchased for investment purpose. You can include some of legal expense for lawyers and title related work.

  • Fixed assets
    • Fixed assets mean the property you bought. For your calculation, you need to calculate your adjusted basis. You can include some of legal fees and transaction fees into the adjusted basis.
  • Depreciation
    • The main reason why you buy your property! If your property is for investment, you can depreciate. You can reduce your taxable income by the yearly depreciation. Here is for mode details.

Liabilities usually includes 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. You will keep paying the principal until you pay off.
  • Interest payable
    • Interest expense that you have been charged but not made payment 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 income statement, which is explained below, is also the part of Equity.

  • Owner’s equity
    • Fixed assets mean the property you bought. For your calculation, you need to calculate your adjusted basis. You can include some of legal fees and transaction fees into the adjusted basis.
  • Retained earnings / loss
    • Accumulated amount of net income or loss over the years since the company was incorporated.
  • Net income / loss
    • The main reason why you buy your property! If your property is for investment, you can depreciate. You can reduce your taxable income by the yearly depreciation. Here is for mode details.

The total amounts of Assets “MUST” equal to the total amount of Liabilities and Equity. That is why it is called Balance Sheet. People call it just “BS” as an abbreviation.

Very basics of real estate accounting (Income Statement)

Income statement has another name, profit and loss statement. People call it just “PL” as an abbreviation.

Income section

  • Rent income
    • Simple.. you receive money from tenant, it is rent income.
  • Capital gain
    • How much you have gained in terms of fair market value since you bought the property.

Expense section

  • Property tax
    • Municipality would send you a tax statement every six months or yearly. It is a tax based on the assessed value decided by the relevant municipality. If you think too high, you may appeal to reduce the property tax.
  • Property management fee
    • This is an expense you pay if you hire a property manager to manage your property. They usually charge you monthly and you record it as an expense.
  • Professional fees
    • Such as lawyer fee and accountant fee. You pay CPA a feel to file tax return but that is not part of tax. The fee should be recorded as an expense, professional fee.
  • Repair and maintenance
    • If a plumber comes and fix your property’s bathroom, thats a repair expense. You pay the fee and record it as an expense. Monthly cleaning expense is also considered to be this expense.
  • Utility
    • Gas, Electricity and Water. Internet and phone bills are not utility.
  • Capital loss.
    • How much you have lost in terms of fair market value since you bought the property.

Manage your documents : Keep EVERY single invoice or statement

This is actually the most important thing for you remember and actually do. Keep EVERY SINGLE DOCUMENT. You will think nah, this is not important enough and throw away some invoices or receipts. Your CPA will not be able to verify those transactions.

IF you get audited by IRS or State, you will have to provide them with the evidences. If you have only paper based evidence, then you need to keep that. In some case, you will have to keep it for 7 years. Here is more details for IRS standard.

Manage your bank account

Another important practice that not so many real estate investor or even property manager do is to manage bank accounts effectively.

If you are an individual real estate investor, you may use your personal bank account as your. I highly recommend you separate your business bank account from your personal. If you commingle your assets with business, your personal asset will be in danger to come after when sued. Nowadays, you can open bank accounts online. Just do it, it will save you when it rains.

Manage rent collection

All of the rent coming into your bank account should be categorized as rent income. If you only care about “accounting”, you can just dump all of them into one big rent income as a category. But if you want to perform some analysis later on such as which tenant has been paying on time and 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 is very important because it can tell more details for rent collection situation.

Rent roll should contain information such as :

  1. Rent amount
  2. Rent due date
  3. Rent paid date
  4. Rent paid amount (Sometimes tenant pays only partial)
  5. Property name
  6. Unit name / number
  7. Tenant name

If you have these accurate information, you can perform a lot of analytics later on such as what type of tenants pay on time and who would not. It is always better to manage rent roll tenant by tenant or unit by unit. I understand that it is bothersome but if you have multiple properties and you will like to sell one or some of your properties one day. If you do not have accurate numbers, it will significantly delay the deal’s speed to close.

Manage expenses account

Just like rent collection, it is always better to manage your expense unit by unit. If one property has multiple units, if possible, it is better to track the expenses unit by unit. Yes, it is tedious but if you have multiple properties, it will definitely help you negotiate your deals when you sell those properties.

  • 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 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.)
  • The relevant property or unit

The last one is very important because that will let you perform some analysis later on. It is such a tedious work. If you pay $1,000 for one vendor that did some work for 3 different properties, it is you that have to breakdown the amount into the relevant property’s amount and record it properly. But again, it will help you significantly later when you sell the property.

Financial Reporting

There are many types of reporting formats in real estate business. Property managers will prepare monthly property report which basically shows cash inflow and outflow usually. Rent roll is also a very useful report but those are different from “Financial reporting”. Financial Reporting most likely include “Balance Sheet” and “Income Statement (Profit and Loss Statement)” which I already discussed earlier. These are the most important financial documents that you have to prepare at least once a year for tax return at least.

Balance Sheet

Balance Sheet is basically snapshot of your financial situation. Every year, it carries over whatever your gain or loss 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 asset, your seller may not be interested. Balance sheet shows the accumulated financial impact on retained earnings if the property has been making money or losing money.

Income Statement

Income statement basically shows how much you are earning or losing of that period (Month, Quarter, Year). It is obviously the important financial statement you need to evaluate the 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 expense

Recurring expenses such as property management fee, utility, broker fee, and etc which I discussed earlier 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. Will it even increase over the years?

Using Balance Sheet and Income Statement, you can calculate the most important number that every single real estate professional uses, that is Capitalization rate, we usually call it Cap rate.

Property Value / Net Operating Income = Capitalization rate

When you sell or buy a property, you negotiate on Cap rate. If you do not have proper understanding for real estate accounting that leads to the Cap rate, how will you even negotiate professionally? This is just basics. Keep on studying and you will become a true high quality real estate investor.

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