What you need to know about the income tax basis of accounting
INSIGHT ARTICLE |
In recent years, more real estate companies have been maintaining accounting records and presenting their financial statements using the income tax basis of accounting, an alternative to using generally accepted accounting principles (GAAP) in the United States. Compared to GAAP, the income tax basis approach typically involves treatments that could make the reporting less complex. For example, under the income tax basis of accounting:
Depreciation ― Depreciable assets are depreciated over periods specified in the Internal Revenue Code, rather than over the estimated useful lives as under GAAP.
Accounts receivable ― Specific receivable amounts are expensed as bad debts when determined to be worthless, rather than estimating a bad debt expense allowance for GAAP.
Acquisitions ― The purchase price for the acquisition of real estate property is generally allocated between real and personal property, whereas GAAP requires an additional allocation for the fair value of any lease intangibles and tenant origination costs associated with acquired in-place leases. Furthermore, property acquisition costs are generally capitalized to the basis of the property acquired, rather than expensed as under GAAP.
Start-up costs ― Organizational, startup and syndication costs are generally capitalized, rather than expensed as under GAAP.
Rental income and expense ― Rental revenue is reflected in income in the year accrued or collected. In contrast, under GAAP, rental income and expense accrue ratably over the term of the respective leases, inclusive of leases which provide for scheduled rent increases or rental concessions (straight-line rent).
Impairment ― A long-lived asset (such as rental property) is not reviewed for impairment if circumstances indicate the carrying value may not be reasonable, whereas such a review is required by GAAP.
Derivative instruments ― Derivative instruments such as interest rate caps and swaps are not required to be recorded at fair value. GAAP requires derivative instruments to be recorded on the balance sheet at fair value, with changes in fair value recorded each period as either “other comprehensive income” or an “adjustment to net income.”
Financial statement disclosures ― GAAP requires certain financial statement disclosures, which may include disclosing the fair value of certain financial assets and liabilities.
As summarized above, there are a number of additional requirements for GAAP reporting, making maintaining such accounting records labor-intensive for a company’s accounting personnel. Furthermore, presenting the financial statements in compliance with current federal tax laws and regulations alleviates the need to keep a separate set of books on a GAAP basis. Maintaining and reporting financial statements under an income tax basis can help simplify the financial reporting process and align your financial statements with your tax returns.
If a financial statement audit is required, investors and lenders may be willing to accept financial statements on the income tax basis of reporting. Generally, a financial statement audit on the income tax basis requires less time to complete than an audit under a GAAP basis. The result is generally lower audit fees.
Therefore, when negotiating operating agreements with investors or loan documents with lenders, you may want to consider incorporating the option of using the income tax basis of accounting into these agreements. As investors and lenders become more flexible regarding financial reporting, there is a real opportunity to reduce costs for accounting labor and financial statement audit fees.