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Real estate is one of the most lucrative markets in the world. But it’s also one of the most complicated. Becoming a successful investor requires a lot of speculation, and if you want to make it big in the market, you have to invest in multiple properties. With all those assets and predictions, you’ll have a lot of numbers to crunch every month, which requires an efficient real estate accounting system.
When you first start as an investor, it’s easy to think that accounting is just a tedious task that only serves to keep you safe from the IRS. But as you gain more experience, you’ll realize that your business relies on efficient accounting. Without it, you won’t be able to make thoughtful financial decisions, know where your money is going or stay on top of maintenance and employee management.
The key to any sound system is being organized. You’ll need a process for collecting financial information, a system for storing and filing that information, and a method for using that information to analyze your decisions and measure how profitable your properties are. That’s a lot to handle for even an experienced investor. Thus, we’ve created this ultimate guide to help you design a system that works for your business.
Why Should I Learn Real Estate Accounting?Why Should I Learn Real Estate Accounting?
Unless you’re a property investor, it might not be obvious why you should learn about real estate accounting. But if you work with real estate in any capacity, understanding the fundamentals of proper accounting is well worth the effort. It is the case if you:
- Run a real estate agency
- Manage real estate for clients
- Handle the accounts of a housing association
- Run a building construction firm
- Manage an investment trust
- Provide residential sales
Real estate accounting, or real estate bookkeeping, is your scorecard for knowing how your business is doing. You could spend all year finding deals, acquiring money, and generating cash flow. But what’s the point if you don’t keep an efficient record of it through bookkeeping? It’s like scoring a touchdown with no scoreboard. By developing an efficient, organized, and easy-to-use bookkeeping system, you can:
- Keep track of vital performance measurements like net operating income, cash flow, profit, and net worth.
- Compare your growth rate (or lack of growth) yearly.
- Manage your cash, so you don’t go broke.
- Know what business strategies worked and those that didn’t
- Know which rental properties are generating a profit and which are causing a loss
- Easily prepare and file your yearly tax returns.
- Save money on tax preparation since your CPA doesn’t have to bill you for extra time spent getting your information organized correctly.
- If you get an IRS audit, avoid spending time and stress digging for the proper documents.
- Avoid IRS tax penalties or backed taxes because you have the materials needed to defend deductions you claimed
- Pay all your bills on time and as agreed.
- Raise capital from lenders and partners by presenting them with accurate data on past performance
All this sounds great, but it also looks like a lot of work. Accounting can sometimes be a tedious drag; nobody does this for fun. But if you ever hope to run a successful business, you have to be willing to do the work that success in anything requires.
Can’t I Hire an Accountant to do all this for me?Can’t I Hire an Accountant to do all this for me?
Yes, you can, and you probably should if you have an extensive portfolio to manage. But delegating the task entirely to someone else is still no excuse for not learning the fundamentals of proper accounting. Use the time with your accountant to learn about managing the financials. How can you say you understand if you don’t know how your business runs behind the scenes?
For investors just starting, learning the skills and knowledge of proper bookkeeping should be considered mandatory. Once your portfolio has grown enough to warrant hiring a professional accountant, you’ll be better positioned to vet their competency for the job and work more efficiently with them. You’ll also have a far better sense of your actual financial situation, which will come in handy when you’re in tough negotiations for a new purchase or sale.
Steps to Creating Your Accounting SystemSteps to Creating Your Accounting System
1. Understand the real estate accounting regulations you have to follow1. Understand the real estate accounting regulations you have to follow
The first thing to start with is learning about the federal rules you’ll have to follow. These guidelines will shape your accounting practices and be followed to avoid any trouble with the IRS. The purpose of these regulations is to:
- Protect investors
- Maximize industry contribution to the gross domestic product (GDP)
- Encourage the distribution of wealth
- Prevent the mistakes that led to the 2007 financial crisis
Mistakes can happen, but intentional manipulation of your accounting is considered a white-collar crime and may warrant prosecution. These accounting standards are set by the Financial Accounting Standards Board (FASB). You can review these standards on their website. There are many rules and regulations to cover here, so be advised to seek advice from an accounting firm specializing in real estate.
2. Choose a real estate accounting method2. Choose a real estate accounting method
When deciding how to record all your transactions, you have two methods: cash basis or accrual. Both approaches have their own rules for recording transactions and come with their pros and cons. Cash-basis accounting is the simpler of the two. Each time you exchange cash, you make an entry — record income when you receive it and record expenses when you pay it.
Accrual accounting is a little more complicated and involves making two entries for every transaction, a debit and a credit entry. It is also called double bookkeeping and is a much more secure method for recording your transactions. The beauty of this approach is that it allows for a straightforward equation, Assets = liability + equity. Your combined liability (money that you owe) and equity (the value of your company) must always equal your assets (something you own that generates cash flow, i.e., a property). If there’s a discrepancy, then an error has been made somewhere.
Accrual is a far better accounting method; some businesses are even required to use only accrual accounting. But depending on your current circumstances, the cash-basis method may suit you better for now. If you ever wish to change your accounting method, you’ll need to request this with the IRS. The IRS will know how you use it once you send them your first business tax return.
3. Get a system for recording entries3. Get a system for recording entries
You have a few choices when deciding how you’ll record your entries. If you can afford it, you can hire a Certified Public Accountant (CPA) and leave it to them. But if you’re starting as an investor or only have a tiny portfolio, you can use accounting software. Using a system designed specifically for accounting is much better than using spreadsheets. Most of them are cloud-based, making updating or modifying them easy anywhere you have an internet connection. Do plenty of research before deciding on which software to use. Check out Techradar pro for a list of the current best accounting software.
4. Set up your chart of accounts4. Set up your chart of accounts
You’ll need a chart of accounts to record and organize your transactions. This will list all the deals you’ve ever conducted and allow you to create reports, measure performance, and locate specific transactions when needed. You can design this on a spreadsheet using either Excel or Google Drive. A chart of accounts usually includes at least three columns:
- Lists the account names
- Lists the type of account (asset, liability, equity, income)
- It contains a description of the kind of transaction, so you know what it is for
Each time you make a transaction, enter it under the appropriate account. Keep your chart of accounts regularly updated to keep your records accurate.
5. Separate personal and business funds5. Separate personal and business funds
You’ll need a business bank account for all your real estate transactions. It keeps all your money in one place and allows you to easily see your bank statement and transactions that have been processed and are still pending. A separate bank account also makes you look more credible and professional in the eyes of your clients. You’re creating confusion if you don’t separate your personal and business transactions.
6. Organize all your supporting documents6. Organize all your supporting documents
Without all your supporting documents, you’ll have no way to prove where your money has gone or where it has come. There will be a lot of different papers to handle for each property, but the most important will be:
- Invoices and receipts
- Bank statements
- Credit card statements
- Tax returns
- Insurance information
You can store your documents in hard copy, digitally, or both. Whichever way you choose, ensure you have a system for filling and tracking them so you can easily find a specific one when you need to. If you store digitally, then take some time to decide what platform to use. You’ll want a secure platform that will keep all your data safe.
7. Fine-tune your income collections7. Fine-tune your income collections
Payment collection can be challenging to stay on top of if you have a growing business. Without an efficient system for income collection, you’ll waste a lot of time and have difficulty planning. Fortunately, it’s not that hard to fine-tune your collection process, so it stays efficient. You have to create practical payment terms on your invoices. You can do this by doing the following with your invoices:
- Include all necessary sections in your invoices, such as contact information, due date, and the amount owed
- Use short payment terms to get paid faster.
- Number each invoice so you can keep track of them
- Send all invoices promptly to avoid delays
- Have a process for flagging and contacting delinquent payers
- Always be polite and professional when communicating with your clients
- Split any large bills into multiple payments
You can make this much easier by automating your invoices through an online system. A service like QuickBooks.com will allow you to do all of the above.
8. Reconcile your bank account8. Reconcile your bank account
Keeping track of your transactions is one thing, but you must also ensure they’re showing up correctly on your bank account balance. To keep your books accurate, compare them with your bank account on at least a monthly basis. Making a habit of this will allow you to catch any differences early and rectify them. It would be best to watch for any accounting mistakes, bank errors, timing delays, and other discrepancies that could cause you problems.
9. Classify your workers9. Classify your workers
As your business grows, you’ll likely need to hire extra people to help manage and maintain your properties. You’ll need a property manager overseeing and running your rental properties, independent contractors when you need to do some maintenance or renovations, and real estate agents when you’re looking to buy or sell a property. The number of different employees and contractors you’ll have to keep track of at other times can get confusing. That’s why you’ll need a system for keeping track of them. An essential step is appropriately classifying them as either employees or independent contractors. It can have enormous repercussions for your taxes and wages.
For example, when you classify someone as an independent contractor, you do not deduct taxes from their wages or pay employee taxes. Additionally, contractors; are not covered by the FLSA rules on minimum wage and overtime pay. However, all of the above does apply to employees. If you’re unsure how to classify a worker, you can use the U.S. Department of Labor’s six-part economic realities test. You can also learn more about the difference between a contractor and an employee in New York State by checking out the ny.gov website.
Know what real estate taxes apply to youKnow what real estate taxes apply to you
Proper accounting isn’t just about helping you avoid trouble with the IRS. It will also help you save money on taxes, so you know which ones are relevant to real estate. This article can go through the complete list of NYC real estate taxes.
Final ThoughtsFinal Thoughts
Every system is only truly as good as the people that designed it. Have a professional accountant check your books every few months. Doing this helps fix errors, highlight tax savings you could be missing out on, and ensure that everything is up to date on the latest regulations. Bookkeeping can be tedious, but you’ll see its worth with time. Beyond the practical benefits, proper accounting can bring you immense satisfaction and confidence. By knowing your numbers, you’ll be setting yourself up for years of growth and substantial earnings in the years ahead.