The real estate industry has grown exponentially in the last few decades, with almost every capable person leveraging real estate to make a profit. Whether you are a landlord renting their property out to tenants, an investor, or a real estate professional or broker, you need at least fundamental knowledge of Real estate accounting.
Property is an immensely tricky matter, and the government imposes strict regulations and legislation to keep everyone honest, which means that on your end, you need to make sure your accounting is in order. You cannot risk mismanaged financial statements and paper trails, as they can create immense problems for you and even result in criminal liability if you make one wrong move.
This is why we at EA will tackle this highly sensitive and important topic today, where we will discuss Real estate accounting comprehensively.
So, whether you are a property owner, investor, or Real estate professional, don’t leave money on the table in your real estate investments. Learn the basics of real estate accounting and watch your profits soar!
Table of Contents
What is Real Estate Accounting?
Real estate accounting is the recording and analyzing of the financial information of various real estate properties, whether residential or commercial. It’s similar to regular business accounting, but things get tricky below the surface.
Do you remember any complicated word problems in your high school math class? If you do, you might recognize terms such as depreciation, rental income, mortgage payments, property taxes, and property appreciation. You might experience a blast from the past!
These terms are relevant to real estate accounting, and we will discuss them in detail to help you get started with Real estate accounting!
Tracking Rental Income and Expenses
Rental income is any payment you receive for the use or occupation of the property. Additionally, any property or services rendered in exchange for the use or occupation of property is also rental income, and the fair market value of these services must be reported as part of the income.
Rental expenses are incurred for the maintenance and regular operation of rental property and can be written off as a business expense.
If tenants cover any expenses relating to the property, for example, the water bill, and deduct that from the rental payment, that must also be reported separately alongside the net income, and the cost of the bill can be deducted as a rental expense.
Understanding Property Depreciation and Appreciation
When you rent out your property, you use the buildings to generate income, much like a factory owner uses machines.
The IRS recognizes that the market value of your property goes down or “depreciates” every year as you maintain it (typically at a rate of 3.6% as per Rocket Mortgage), and they allow you to subtract this amount from your taxable income. This lets you have lower taxes or even move down to a lower tax bracket, which benefits business. This whole process is called property depreciation. Check out this in-depth article on depreciation from Investopedia to learn more.
On the flip side, property appreciation is when a property gains value over time. This can happen because of developments in the area, increased job opportunities, and inflation, among other factors.
You can also spend money to improve the value of your property, which can then be leveraged to make a profit when selling the property or increase the rent based on the improved market value.
Remember that you will be subject to paying the Capital Gains Tax when you sell a house that has appreciated dramatically. For example, you buy a home for $200,000, and the market value increase allows you to sell it for $600,000 three years later. You will be liable for tax depending on where you fall on the IRS’ scale and must pay that tax when selling the property.
Mortgage Payments
Typically, you do not trade money for property when selling a house. Most people buy homes with aid from a mortgage lender, typically a bank. If you are in the real estate business and looking to flip houses, i.e., buy a house, renovate it, and sell it for more, then you need to learn how a mortgage works.
A mortgage is the amount owed to the lender who financed the house purchase, and the loan is paid off in installments with interest over time.
Many fledgling house-flippers dabble in the business by financing the purchase of a home and then selling it for a profit. This means they must sell it for an amount higher than the remaining mortgage payment and close the mortgage account once the sale is done.
Thus, you need to make a game plan that accounts for the mortgage and renovation costs and then decide the property’s sales price, which will generate enough profit to justify the work involved.
Generally, house flipping is only advised for real estate tycoons with the capital needed to invest without needing a loan, as this can make things a whole lot easier. Here is a useful link to a mortgage calculator for you to use to compare mortgage rates from different lenders.
Analyzing Real Estate Investments
Financial statement analysis is critical for evaluating the performance of your real estate investments. Key metrics and ratios include:
- Return on Investment (ROI): ROI measures the profitability of your investment relative to its cost. It helps determine if your investment is meeting your financial expectations.
- Cash-on-Cash Return: This metric calculates the annual cash flow generated by the property as a percentage of the initial cash investment.
- Net Operating Income (NOI): NOI is the total income generated by the property after deducting all operating expenses but before accounting for debt service or taxes.
- Capitalization Rate (Cap Rate): Cap rate measures the property’s potential return on investment and is calculated by dividing NOI by the property’s current market value.
Accounting for Real Estate Partnerships
Oftentimes, you will need to partner up with fellow investors to pursue real estate ventures. You must keep all the numbers straight and the accounts tidy.
Where and when money moves around for the venture must be clearly defined in your financial statements, and a strict partnership agreement that sets the terms for how the accounting and bookkeeping will be handled must also be set. Partnership account typically entails:
- Properly documenting the partnership agreement and the roles and responsibilities of each partner.
2. Establishing a clear accounting system that tracks each partner’s contributions, share of profits, and distributions.
3. Providing regular financial statements to all partners to keep them informed about the venture’s financial performance
Conclusion
Real estate accounting plays a pivotal role in the success of any real estate venture. By understanding the nuances of real estate accounting, you can make well-informed decisions, optimize your tax liabilities, and maximize profitability. Stay up-to-date with the latest accounting practices, industry regulations, and technological advancements to ensure your real estate business remains competitive and financially sound in 2023 and beyond.
Expertise Accelerated as your Real Estate Accounting Assistant
While we hope that we did a decent job breaking down real estate accounting for our readers, we cannot stress enough the importance of consulting with financial professionals regarding real estate accounting. This is a very messy business, and small mistakes can snowball into massive fiascos in the blink of an eye, so it’s best to leave this part of the job to someone qualified to handle it.
Expertise Accelerated’s real estate accounting services may be the solution for any budding real estate tycoons. EA offers US real estate business owners the ability to enlist the services of any number of offshore real estate accounting talent, all at a fraction of the cost required to hire a US equivalent and with no difference in competency.
These may sound like bold claims, but rest assured, led by Mr. Haroon Jafree and his A-team of star accounting professionals, EA will be up to the task for all your real estate accounting needs. Sign up for a free consultation with Haroon today and let your profits soar! We wish you the best in your real estate accounting endeavors!