This paper presents the basic accounting framework that most landlords should use to properly account for their properties.
Copyright 2006 by Will Johnson, wjhonson@aol.com
All rights reserved.
Introduction
A short glossary
Buying the property
Monthly transactions
Common irregular transactions
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Introduction
Most landlords are not accountants. Some landlords are interested in how to do the accounting for their property, some aren't. Even the ones that are interested may hire accountants, but some prefer to learn how to do their own accounting. This document, cuts through all the mumbo-jumbo and gives actual, concrete examples of how to account for various common events landlords face.There are two methods of accounting that a landlord might use: the accrual method, and the cash method. The cash method is simpler to understand and so that is the method I will use throughout this document. The cash method is the way most non-accountants think. When you get money, it's income right then. When you spend money, it's an expense right then.
The accrual method, in a nutshell, projects what income you will receive or should have received, and what expenses you will pay or should have paid. To my way of thinking it's too complex for 98% of landlords.
So with that disclaimer, let's begin.
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A Short Glossary
An Asset is a thing you "own" even if you're making payments on it. Examples include: a house, a car, a rare book collection, stocks, bonds, furniture, a part or entire interest in a business, a bank account, cash.A Liability is a thing you "owe", usually but not always tied to a corresponding asset. Examples include: a loan on a house, a loan on a car, a margin debt (when you buy stocks with the broker's money), credit card debt, a loan from your parents, student loan. A special form of liability, for landlords is "accumulated depreciation". This is not technically something you "owe", but it has the effect of depressing the book-value of an asset, and it becomes enormously important when you sell the property.
Income is any asset you take in. Examples include: your paycheck, gifts, customer payments on your business invoices (the invoice itself is not income, only payments on it are).
An Expense is any asset you dispose of. Examples include: paying bills, giving gifts, donations to charity, things you buy to consume or resell in a business.
A Bill is when someone else is claiming money from you.
An Invoice is when you are claiming money from someone else.
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Buying the property
Okay, so you've saved $20 grand and buy a rental property with a sales price of $100 grand. You finance the $80 grand with a bank loan, and you have $4 grand in expenses. Some people might be tempted to just create a new Asset "My Rental" with a value of $100 grand, and a new Liability "Rental Loan" with a value of $80 grand. Although you could do that, after just a short time you will find that your tax return entries drift further and further from your book entries. Not only will this cause you headaches at tax time, and also when you sell the property, but it will cause you to miss-out on some nice tax advantages to owning rental property.Here is the proper way to account the transaction. Since you're going to be a land baron, you don't want to create accounts like "My Rental" instead name them something like "1820 Oak Street". For the purposes of this document I will just use "Rental #1", but feel free to replace that with whatever you wish.
1) Create a new asset "Land - Rental #1". This represents only the value of the land you purchased, not the building, barns, sheds, equipment, carpets or any other thing purchased. Initially you will fix this as ten percent of the purchase, so in this case $10 grand. (This will change later.) The reason for seperating the land from everything else, is that you cannot depreciate land and this is going to be important as you will see shortly.
2)Create a new asset "Fixtures - Rental #1". Enter the seperate value of furniture (for an apartment you furnish yourself), each appliance (refrigerator, range, washer, dishwasher) and each unit's flooring (carpet, linoleum, pergo, etc.) to the best of your ability. Be sure to mark which item is where so for example an entry like "Unit 3's Refrigerator $450.00". The reason for entering each of these seperately will become apparent when we get more into depreciation and expenses below. Let's say for our example, that after you've made all these entries, your register balance, for this account is $8,000. These items are 5-year items, they can be fully depreciated over five years. So your annual depreciation expense for all of these together is one-fifth of $8000 or $1600 per year. Go ahead and make an entry, one year forward of your closing date for $1600. See Form 4562 Instructions for more details about depreciation.
3)Create a new asset "To Amortize - Rental #1". In this account put, as a positive figure, your loan origination fee, loan discount points, mortgage insurance application fee and assumption fee. These items are on your HUD-1 statement as lines 801, 802, 806 and 807. Take the total of this account, and divide it by the number of years your loan is long. Let's say the total of these four items is $3500 and your loan is a 15-year loan. You divide $3500 by 15 to get $233.33 which is your current yearly amortization expense. Make an entry, one year from the closing date, enter this amount $233.33 and record it with a category Rental Mortgage:Amortization Expense. You can go ahead and record all the entries, one per year, for each year of the loan now, but I wouldn't. Instead, this item, appearing in your Net Worth will serve as a reminder to record the expense for the next year. This expense goes to your tax return, Schedule E (Rentals), on line 12. No matter what your mortgage lender or banker calls it, it's Mortgage Expense. (Instructions for Schedule E) This is a yearly expense over the life of the loan, when you sell the property, any remaining balance in this account should be deducted in full, for that selling year, as a current year expense.
4) Create a new asset "Cost Basis - Rental #1" This will have an initial value of the purchase price ($100 grand), minus the land account ($10 grand) and minus the fixtures account ($8 grand), but plus any of the expenses incurred in obtaining the property (except loan-charges, and charges which create assets, like pre-paid charges). Here is a two-page article on exactly which closing costs you add to your cost basis, and which are current expenses, assets or liabilities. Let's say out of the $4000 in expenses, you have $1600 in these sort of expenses. This "Cost Basis" asset would then have an initial value of $100,000 - $10,000 - $8,000 + $1,600 = $83,600.
5) Create a new liability "Rental #1 Loan" This has an initial value of $80 grand. (You did that right the first time!). However, if your loan has a prepayment penalty, create another liability account to hold that penalty. Let's say the penalty is 5% of the loan balance. Create another liability account "Rental #1 Prepayment" with a balance of $4000. If the prepayment expires completely in two years, then make an entry, right now, with a date two years from now, to zero out the account. Not only will this account remind you of when the penalty expires, but it will help you to not take a hit in your Net Worth if you do have to sell prematurely. Also when it does expire, provided you haven't yet sold, you'll get a nice boost to your Net Worth for doing nothing!
6) Create a new invoice account "Rental #1 Income Receivable". Enter the prorated rents, which you received on your HUD-1 when you purchased, as invoices. Then immediately enter the prorated amounts as payments against them, so the register shows a zero balance. Then immediately enter, as invoices, the rents for the following month. Always create your rent income invoices in advance, as invoices due on the 1st of each month. These will not show up as income, until you actually receive payments so they won't hurt you at tax time, should your tenants not pay on time. But they will show up as Assets so they will boost your net worth. These are receivables, that is, you are expecting to get them, but you haven't yet gotten them. So they are an asset, in that you "own" them, but they are not income unless you receive payment.
7) Create a new liability account "AD1F - Accumulated Depreciation - Rental #1 Fixtures". This account has a current value of zero, because you depreciate as things age, not immediately. These items can be depreciated over a five-year period. So, let's right now project forward, by entering, with a date a year in the future, the straight-line depreciation of $1600. This is one-fifth of the our $8000 fixture balance.
8) Create a new liability account "AD1B - Accumulated Depreciation - Rental #1 Building". This account has a current value of zero, because you depreciate as things age, not immediately. The building, unlike fixtures, must be depreciated over the much longer term of 27.5 years. So let's right now project forward, by entering, with a date a year in the future, the straight-line depreciation amount of $3040 with is our Cost Basis - Rental #1 balance of $83,600 divided by 27.5.
--Note: If you had considered the fixtures as part of the property, you would have lost out on $1600 a year in depreciation expense. Here's some more on depreciation.
9) Create a Security Deposit liability account. Each of your tenant's paid a security deposit when they moved in, and these should have been credited to you in your HUD-1 when you bought the property. You now need to enter those amounts, for each unit, so you can keep track of them. These are a liability.
10) Clearing account. I always recommend creating a clearing account as an Asset. This account is used to hold a set of minor transactions that will balance each other out within one or two days. It is a great help for remembering how you did certain transactions. We'll see some examples later in this paper.
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Monthly transactions
Certain transactions are typical per month.1) Invoicing for rent. Pretty straight-forward. By the way, if you've gotten "last month", this is called "Pre-paid Rent". It's not an Asset, it's a liability. You are "holding" it for the tenant. When the last month arrives, your invoice for that month which is an Asset, cancels out the liability.
2) Receiving rent payments. These are applied against the invoices. If a tenant moves out without paying rent, you'd apply a credit to zero the invoice for that month. You would then zero their security deposit, possibly generating also a check for any balance you repay to them.
3) Paying a manager. If you have a manager, make sure you enter the payments into a Property Maintenance category, that is tied to a Tax line on your Schedule E. You don't want to overlook this expense at tax time.
4) Pay the Utilities. Some people like to have a Rental 1 Utilities bill account, it's your choice. Bills do not affect your Net Worth until you pay them. When you pay, make sure you account the payment to a Property Utilities category, that is tied to a Tax line on your Schedule E. Rental utilities that you pay may include garbage, sewer, water, electricity, gas and cable.
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Common irregular transactions
1) Disposing of a fixture.
One of your tenants ranges, is old or broken and you want to get a new one. There are several ways to do the accounting for this, depending on exactly how you "get rid" of the old one. (But again, my focus will be on the one most advantageous to the property owner trying to keep things simple.)1A) Sell the old range for cash. Then, buy a new range with that cash, plus added cash. To account this, you debit both the original value and the accumulated depreciation, and then balance the difference with the cash received and an adjusting income or expense item for the remainder. Your loss, if any, is deductible in its entirety on your tax returns for the current year. Your Cost Basis for the new Fixture is what you paid for it.
1B) Trade in the old range for a new range plus cash. In this case, you are required to add any Loss to the Cost Basis, but in no case can it be more than the Market Value. This is not good if your Fixture has depreciated faster than you are allowed to account the depreciation. You will lose the benefit of the loss in part. However, a trade-in is the most common way people obtain new fixtures. Typically the trade-in is given some nominal value like fifty dollars, just to get you into the store.
1C) Donate the old range to a charity. While this might look useful from a tax perspective, it can be more of a hassle when trying to prove to the IRS why you've donated six appliances in the past two years. In my opinion, it would be better to sell them, even for scrap, as this is less likely to generate questions.
I prefer method 1A and I will show you the exact accounting you would do for it. Let's say the original value of the range was $450 and it broke after two years of use. Since fixtures are items which can be depreciated over five years, you will have taken two years worth of depreciation on it. The depreciation expense for this item would be $90 per year, so you would have taken $180 of depreciation, leaving a book value (the remaining value) of $450 - $180 = $270. It's unlikely you'll actually get $270 from a broken or old range, so let's say you sell it to a used appliance shop for $100, this means you've realized a $170 loss. Now you go out and buy a new range for your tenant, for a sales price of $600.
Your accounting entries are: A) Make an $450 entry to subtract from the Fixtures account with a memo "original value" by a Transfer into the Clearing Account; B) debit the "Accumulated Depreciation - Fixtures" account for $180 with a transfer into the Clearing Account; C) at this point your clearing account should show a balance of $270; D) from the Clearing Account debit it with a Transfer into the "Petty Cash" account for $100 (if you received a check instead of cash, your Transfer would be into your Personal Undeposited Payments account); E) and finally debit it with an expense item of Misc Exp:Real Estate with a memo line "loss on fixture sale" for an amount of $170. At this point your Clearing Account should be zero. On the very very odd change that you get a higher sales price than the remaining book value, you're going to have to recognize this as Misc Inc:Real Estate and end up paying tax on it.
This sale for salvage value, and purchase of a new item has the advantage that each fixture starts over with a "clean" depreciation history. That is, you have no carryover of cost basis from an old fixture to a new one. The other advantage is that you can expense as a loss your full loss without regard to market value, since the implicit assumption is, that if you sold it for cash, you sold it at market value (or less).
We are almost done. You've sold the old range, now you buy the new one. Enter the new range in your Fixtures account, removing money either from Petty Cash, Bank Account, or Credit Card depending on how you pay. That is, your Cost Basis is exactly what you paid for it. Simple!
Be sure to adjust your projected depreciation to account for the new Cost Basis. Remembe way at the top that are total yearly depreciation expense was $1600. Well now you've gotten rid of one of the underlying items that made up that total, so we have to adjust it. Our depreciation for this range was $90. Removing that from the total we are left with $1510 for everything else. The new range you bought was $600, and one-fifth of that, which is the allowable yearly depreciation expense for it, would be $120. So your new annual depreciation expense is $1510. Adjust your future "Accumulated Depreciation - Fixture" entries, (which you dated from the date you bought the property), to now say $1510. Now add another entry for this range alone, one year from the day you bought it, for $120. This is simple. If you get five or more seperate items to track, then you can prorate the depreciation to bring them all to the same month and then consolidate the entries. Perfectly acceptable.