What you need to know about the income tax basis of accounting
Determine if it is right for your real estate firm
INSIGHT ARTICLE |
This article was originally published on Oct. 4, 2018 and has been updated.
Removing unnecessary complexities from a real estate firm’s financial reporting process can be a cost-effective and value-added benefit to its investors. An easy step many in the real estate industry have taken is to maintain property-level financial statements consistent with the accounting basis used in preparing its federal income tax returns (income tax basis of accounting).
The income tax basis of accounting is a comprehensive basis of accounting which can be an alternative to accounting principles generally accepted in the United States of America (GAAP). Depending on the circumstances, the income tax basis of accounting may be useful and meaningful to management, credit grantors/debtors, and to certain investors.
Many time-intensive principles required by GAAP are not applicable under the income tax basis of accounting thus allowing accounting professionals instead to focus on a real estate firm’s strategies surrounding fundraising, capital deployment and technology. Additionally, property operations reported under the income tax basis more closely follow cash flows utilized in underwriting to streamline due diligence and property valuations for investor reporting
Other than the market value, real estate investors want to be confident in the actual cash flows and operations of the investment properties and understand potential impacts to their eventual tax dollars. Using the income tax basis of accounting can accomplish this and will also help provide clarity into understanding the details and reconcile K-1s provided to investors and the federal income tax return to the financial statements.
By reporting under the income tax basis of accounting, your audit and tax professionals will be aligned to advise on distinct tax considerations pertinent to the structure, investor mix and operations of your business and ensure accurate presentation of annual financial statements and disclosures requirements. Here at RSM, our audit and tax professionals work as one team to seamlessly provide your services with a less onerous outcome for management.
Below are examples of common differences between the income tax basis and GAAP which will provide overall cost/time savings for real estate firms:
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 creating a bad-debt policy and 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 value of any lease intangibles and tenant origination costs including marketing and legal costs associated with acquired in-place leases.
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 (if a lessee entity has not yet adopted the new accounting standard for leases), 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). GAAP would require a tracking mechanism for lease income recognition. Additionally, if the entity has adopted GAAP’s new accounting standard for leases, the lessee entity would need to recognize a right-of-use asset and a corresponding lease obligation.
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” and a determination as to whether hedge accounting is appropriate. If hedge accounting is elected, further requirements are needed to comply with GAAP.
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 several GAAP principles requiring added time, costs, and complexity where it may not be needed by certain users of a real estate firm’s financial statements. There may be other differences between GAAP and the income tax basis of accounting affecting your firm’s financial statements. 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.
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. If an audit is required for annual reporting, time associated with the added GAAP principles will not be required under the income tax basis of accounting, generally resulting in lower audit fees.
When making the decision as to the right basis of accounting for your real estate firm, consult with a professional.