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 really want to make it big in the market then you have to invest in multiple properties. With all those assets and speculations, you’ll have a lot of numbers to crunch every month and that requires an efficient accounting system.
When you’re first starting out 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 come to realize that your whole 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 good system is organization. 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. This is why we’ve created this ultimate guide to help you design a system that works for your business.
Table of Contents
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 then understanding the fundamentals of good accounting is well worth the effort. This is definitely 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 more specifically 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 if you don’t keep an efficient record of it through bookkeeping, then what’s the point? 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 key performance measurements like cash flow, profit, and net worth
- Compare your growth rate (or lack of growth) from year to year
- Manage your cash so you don’t go broke
- Know what business strategies actually 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
- Avoid extra time and stress digging for the right documents if you get an IRS audit
- Avoid IRS tax penalties or backed taxes because you have the documents 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 real data on past performance
All this sounds great, but it also sounds like a lot of work. Accounting can be a tedious drag at times, nobody does this for fun. But if you ever hope to run a successful business then you have to be willing to do the work that success in anything requires.
Can’t I Just Hire an Accountant to do all this for me?
Yes, you can, and you probably should if you have a large portfolio to manage. But delegating the task entirely to someone else is still no excuse for not learning the fundamentals of good accounting. If you don’t understand the basics of how your business runs behind the scenes, then how can you say you understand it at all? Knowing how your accountant works will allow you to use the financial information they give you more efficiently and make smarter decisions when it comes to buying and selling.
For those investors who are just starting out, learning the skills and knowledge of good bookkeeping should be considered mandatory. Once your portfolio has grown enough to warrant the hiring of a professional accountant then you’ll be in a much better position to vet their competency for the job and work more efficiently with them. You’ll also have a far better sense of your true financial situation which is sure to come in handy when you’re in tough negotiations for a new purchase or sale.
Steps to Creating Your Own Accounting System
1. Understand the real estate accounting regulations you have to follow
The first thing to start with is learning about the federal regulations you’ll have to follow. These guidelines will shape your accounting practices and must be followed if you’re 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
These accounting standards are set by the Financial Accounting Standards Board (FASB). You can review these standards on their website. Mistakes can happen but any intentional manipulation of your accounting is considered a white-collar crime and may warrant prosecution. There’s a lot of rules and regulations to cover here so it would be advised that you seek advice from an accounting firm that specializes in real estate.
2. Choose an accounting method
When it comes to deciding on how you’ll record all your transactions, you have two methods to choose from, cash basis or accrual. Both methods have their own rules for how transactions are recorded and come with their own 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 single transaction, a debit, and a credit entry. This 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 very simple 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 cashflow i.e. a property). If there’s a discrepancy, then an error has been made somewhere.
Accrual is a far better choice as an 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. The IRS will know which method you use once you send them your first business tax return. If you ever wish to change your accounting method, then you’ll need to request this with the IRS.
3. 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 just hire a Certified Public Accountant (CPA) and leave it to them. But if you’re just starting out as an investor or only have a very small portfolio, then 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 it easy to update or modify them from anywhere that you have an internet connection. Do plenty of research before deciding on which software to use. Check out this article on Techradar.pro for a list of the current best accounting software out there.
4. Set up your chart of accounts
To record and organize your transactions you’ll need a chart of accounts. This will list all the transactions you’ve ever conducted and will allow you to create reports, measure performance and locate specific transactions when you need to. You can design this on a spreadsheet using either Excel or Google Drive. A chart of accounts usually includes at least three columns:
- Account – Lists the account names
- Type – Lists the type of account (asset, liability, equity, income)
- Description – Contains a description of the type 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 funds
You’ll need a business bank account for all your real estate transactions. This keeps all your money in one place. It also allows you to easily see, through your bank statement, what transactions have been processed and which are still pending. If you don’t separate your personal and business transactions, then you’re setting yourself up for a lot of confusion. A separate bank account also makes you look more credible and professional in the eyes of your clients.
6. Organize all your supporting documents
Without all your supporting documents you’ll have no way of proving where your money has gone or where it’s coming from. There will be a lot of different documents 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 on what platform to use. You’ll want a secure platform that will keep all your data safe.
7. Fine-tune your income collections
Payment collection can be a difficult thing to stay on top of if you’ve got a growing business. Without an efficient system for income collection, you’ll waste a lot of time and have a hard time planning ahead. Fortunately, it’s not that hard to fine-tune your collection process so it stays efficient. You just have to create effective 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 a lot easier by automating your invoices through an online system. A service like Invoicesunlimited.com will allow you to do all of the above plus more.
8. Reconcile your bank account
It’s one thing to keep track of your transactions but you also have to 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. You should keep an eye out for any accounting mistakes, bank errors, timing delays, and other discrepancies that could cause you problems. Making a habit of this will allow you to catch any discrepancies early and rectify them.
9. Classify your workers
As your business grows, you’ll likely need to hire extra people to help with managing and maintaining your properties. You’ll need a property manager for 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 different times can get confusing. That’s why you’ll need a system for keeping track of them. A very important step with this is properly classifying them as either employees or independent contractors. This can have huge 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 you
Good accounting isn’t just about helping you avoid trouble with the IRS. It will also help you save money on your taxes so know which ones are relevant to real estate. You can go through the full list of NYC real estate taxes on this article.
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 regularly helps with fixing errors, highlighting tax savings you could be missing out on, and ensuring that everything is up to date on the latest regulations. Bookkeeping can be a tedious chore at times, but with the time you’ll see its worth. Beyond the practical benefits, good bookkeeping can bring you an immense feeling of satisfaction and confidence. By knowing exactly what your numbers are you’ll be setting yourself up for years of growth and substantial earnings in the years ahead.