Tax & Accounting for Real Estate

Presented by: Akore Berliner, CPA

Introduction to Real Estate Accounting Concepts

What is Accounting Anyway?

o Tracking Money In and Money Out of a

business.

o Keeping the score

o Is the business winning or losing?
Three Top Reasons Why Accounting Is
Important to Business Owners…..

1. Tax Planning
 Taxes can be nearly 40% of income at the end of the day!
 Good accounting leads to strong tax planning.

2. Theft Avoidance
 Guard your assets!

3. It’s fun.
 Tracking your business should be enjoyable.
▪ If not, you’re in the wrong business.

 Why is accounting important to you?

More Reasons to learn Accounting….
 To communicate better
 with your CPA, Bookkeeper, and other business professionals
 To improve timeliness of info
 To build accurate Financial Ratios & ProForma calcs
 Better decision making
 To strategize at every level
 See detail of everything
 To accurately track the return on your investment
 Owners “think” they know
 Return is all that matters!
 To minimize errors
 Owner awareness is crucial
More Reasons to learn Accounting….
 To communicate better
 with your CPA, Bookkeeper, and other business professionals
 To improve timeliness of info
 To build accurate Financial Ratios & ProForma calcs
 Better decision making
 To strategize at every level
 See detail of everything
 To accurately track the return on your investment
 Owners “think” they know
 Return is all that matters!
 To minimize errors
 Owner awareness is crucial
More Reasons to learn Accounting….
 To communicate better
 with your CPA, Bookkeeper, and other business professionals
 To improve timeliness of info
 To build accurate Financial Ratios & ProForma calcs
 Better decision making
 To strategize at every level
 See detail of everything
 To accurately track the return on your investment
 Owners “think” they know
 Return is all that matters!
 To minimize errors
 Owner awareness is crucial
5 key Terms you MUST know
1. Income
2. Expense
3. Asset
4. Liability
5. Equity
Income Defined
 Why define Income?
 Not all benefits received are considered income (taxable)
 You only pay tax on “Income”
▪ The IRS defines what is income and what is NOT income
▪ Better to receive non taxable benefits.

 IRS Definition: Gross Income includes ALL income from whatever source derived, unless
specifically excluded under the Internal Revenue Code

 If you receive cash on a refinance of your apartment building, is that

considered income?

 There are legal strategies to avoid or defer income by smartly structuring

transactions.
What is NOT income
 Gifts or Inheritances
 from friends / family / strangers

 Life Insurance Proceeds as a beneficiary (typically)

 Return of Capital
 Return of your own money!

 Debt Proceeds
 Any money you are obligated to repay is NOT income.

 Rental Deposits

 Insurance Proceeds to replace lost property

 If you are being made whole after losing something, you do not have income.

 Up to $500,000 of Gain on the sale of your primary residence ($250K if

unmarried, other limits apply)
What is NOT income
 Gifts or Inheritances
 from friends / family / strangers

 Life Insurance Proceeds as a beneficiary (typically)

 Return of Capital
 Return of your own money!

 Debt Proceeds
 Any money you are obligated to repay is NOT income.

 Rental Deposits

 Insurance Proceeds to replace lost property

 If you are being made whole after losing something, you do not have income.

 Up to $500,000 of Gain on the sale of your primary residence ($250K if

unmarried, other limits apply)
What IS income?

Not always cash!

income = FMV of property or services

 3 general categories of income:

1. Sale of Services
2. Sale of Property (inventory or business assets)
3. Sale of Investments (portfolio income)
What IS income? Examples…

 Rental Income (sale of property)

 Net Profit on Sale of Business or Investment Real Estate (sale
of property)
 Wages from your job (sale of services)
 Sales of Stock (sale of investments)
 Sale of inventory (sale of property)
 Interest Income (sale of investments – use of money)
 Dividends (income from investments )
 Certain Fringe Benefits from your job (sale of services)
Income Surprises

 Prepaid Rents
 Cash basis
 “Last Month’s Rent” versus “Deposit”
 Be cautious with wording
 Debt Forgiveness
 On Foreclosure/short sale
 There are ways to avoid this sometimes
 Stolen or Illegally Earned Income
 Trading services for ownership interest
 Development services traded for LLC profits interest.
Expense Defined
 Expenses offset income to determine “Net Profit”

 Expense Defined: Ordinary, necessary, and

reasonable spending incurred while operating
a business.

 INCOME – EXPENSE = NET PROFIT

 Expenses lower the taxable base (taxable income)

Expense Synonyms

 There are many used to describe these items

which offset income:
▪ Expenses
▪ Deductions
▪ Deductible Items
▪ Write-Offs
▪ Others you use?
Limits to Expenses
 Not all monies spent offset income.
 Not all are considered “expense” from an accounting perspective.
 Repayment of Debt
 Purchase of land
 Legally not permitted

 IRS imposes limits on how you are allowed to

use certain expenditures.

 Understand the favorable categories so you can

focus your spending efficiently!
Unfavorable Expense Categories
 Common disallowed expenses
 Personal expenses (i.e., clothing, dry cleaning, personal travel)
 Personal use of real estate
 Items unrelated to a business
 Political Contributions

 There may be a time restriction on the use of the write-off,

forcing you to write-off expenditures over a longer period of
time.
▪ For example, purchases of real estate often are written off over up to 39
years.

 Ideally, you want the quickest deduction possible.

Expense Surprises
 Repayment on the principal on a mortgage is NOT an expense
(it’s a repayment of a debt, liability reduction).
▪ Mortgage Interest IS deductible.
 Returning a Tenant Deposit it NOT an expense, but rather the
return of a Liability
 Payment of a Deposit is not an expense.
 Purchase of land is not a current expense.
 The cost of replacing appliances in your rental unit must be
spread out over 5 years typically.
 You can only deduct 50% of your business related meal
expenses.
 Speculation expenses are not deductible.
▪ Travel to new cities for speculative real estate purchases
Expense Surprises
 Repayment on the principal on a mortgage is NOT an expense
(it’s a repayment of a debt, liability reduction).
▪ Mortgage Interest IS deductible.
 Returning a Tenant Deposit it NOT an expense, but rather the
return of a Liability
 Payment of a Deposit is not an expense.
 Purchase of land is not a current expense.
 The cost of replacing appliances in your rental unit must be
spread out over 5 years typically.
 You can only deduct 50% of your business related meal
expenses.
 Speculation expenses are not deductible.
▪ Travel to new cities for speculative real estate purchases
Mid Point Review….

 Income – Expense = Net income

 Sketch out a Rental Property’s Net Income?

 Rental Income less Rental Expenses
▪ How much rental income was collected?
▪ What are rental expenses?
▪ Mortgage Interest (not mortgage principal)
▪ Real Estate Taxes
▪ Insurance
▪ Advertising
▪ Utilities
▪ What else can you think of?
Rental Income vs. Income Sale of New Construction

 These types of income are calculated separately and expenses

are allocated differently.
 They are two different businesses
▪ Operating a Rental Property: Sale of Property
▪ Selling/Developing Real Estate: Sale of Property

 Net Income must be calculated for each business and

then the appropriate tax rate/rules are applied
▪ Real Estate Tax paid during the year of sale would offset Rental
Operations NOT Gain from Sale
▪ Commissions paid on sale would offset Gain from Sale NOT
rental Operations.
Asset Defined

 What is an asset?
 Something you own
▪ Buildings, stocks, bonds, land, equipment, etc
▪ Investments in businesses
▪ Partnership Interest
▪ LLC Ownership

 Tangible or Intangible
▪ Trademarks, patents, loan costs capitalized
Asset Classes

1. Capital Assets
 Investment Use Assets
▪ Stocks, bonds, vacant lot of land held for speculation

2. Business Assets (ordinary or 1231)

 Any asset used in business
 Rental Real Estate
 Development Real Estate
 Computers used in business
 Appliances
 Inventory

3. Personal Assets
 Assets used for personal purposes
▪ Your home (primary residence)
▪ Your Car
▪ Personal assets can also be capital assets (i.e, jewelry, artwork)
Liability Defined

 What is a liability?
▪ An obligation to repay
▪ A debt
▪ Monies owed by the business

 Examples:
▪ Rental Deposits from tenants
▪ Mortgages payable
▪ Monies owed to investors
Liability Synonyms

 Debt
 Payables
 Leveraged amount
 Amount Owed
 Mortgage
 TD
 Bank Note
 Customer Deposits
 Others?
Equity Defined
 Assets less Liabilities = Equity

 Equity in Real Estate = FMV – Cost

 Equity on an Accounting Report

 Typically not stated at FMV
 Accounting Equity = Cost of assets – Debt payable
 Accounting Equity = Assets – Liabilities
 Net Retained Profits of a business
▪ All earnings of a rental property that were not distrusted to anyone
▪ Typically all profits are eventually distributed or reinvested into the business
 Net Owner Investments into a business
▪ All owner’s monies invested into the business that were not returned
▪ Down payment
▪ Operating Cash Investments
What do these 5 terms give to us?

Net Income
= Income – Expense
Shown on an Income Statement

Net Worth / Equity

= Assets - Liabilities
Shown on a Balance Sheet
Common Accounting Reports

 Income Statement

 Balance Sheet

 Cash Flow Statement

Income Statement

 Aka Profit & loss Statement

 Details All Sources of Income

 Detail All Sources of Expense

 Used for Tax Reporting

 Schedule E for Rental Properties
Sample
Statement
Balance Sheet
 Summary of every item the business Owns and Owes.

 Assets, Liabilities (all Debt), and retained profits and capital

investments.

 Buildings and Mortgages go here.

 Owner Capital Accounts are found in the equity section of a

balance sheet
Sample
Statement
Cash Flow Statement
 Shows net cash provided to business
 Cash Flow = Cash in - cash out
 lustrates cash movement in the business from
three categories:
 Operations
 Financing
 Investing

 Most Important for real estate

 Cash flows are often greater than Net Income for rental real estate due to
depreciation
▪ Owners of real estate ultimately care about net cash flow at the end of the
day (month, year)
Sample
Statement
“Capital”

 The most confusing word in accounting.

1. Capital Account
2. Capital Asset
3. To Capitalize an item
4. The Capitalization of a business
5. Capital itself
6. Capitol
“Capital”

 The most confusing word in accounting.

1. Capital Account
2. Capital Asset
3. To Capitalize an item
4. The Capitalization of a business
5. Capital itself
6. Capitol
“Capital”

 The most confusing word in accounting.

1. Capital Account
2. Capital Asset
3. To Capitalize an item
4. The Capitalization of a business
5. Capital itself
6. Capitol
“Capital”

 The most confusing word in accounting.

1. Capital Account
2. Capital Asset
3. To Capitalize an item
4. The Capitalization of a business
5. Capital itself
6. Capitol
Review
 Be able to identify any transaction as falling into at least
one the 5 key categories.

 Assume a hypothetical LLC buys a parcel of land.

 The LLC takes out a loan and contributes 30% cash.
 The LLC builds a rental property on the land using borrowed
funds as well as fund from investors and owners.
 What categories will these transactions impact?
 Attempt to sketch out the cash flows on your own.

 Think!
The End.