The balance sheet is one of the fundamental reports in accounting. On it, you track the book value of assets that your business controls, such as properties and bank accounts, along with their financing. The balance sheet also shows capital contributions or distributions from owners of the business as well as profits that you have reinvested. This article discusses why a balance sheet is important for real estate investors, a limitation on the information it provides, and how newly purchased properties are added onto the balance sheet.
Do I need a balance sheet for my rental properties?
Many investors don’t think about their balance sheet as they begin to track the operating income and expenses from their properties. However, your balance sheet records the basis of your properties, which you or your CPA will need to calculate your annual depreciation expense at tax time. You’ll also need it to file taxes upon the sale or 1031 exchange of a property. Finally, your balance sheet provides a snapshot of other metrics for your business’s overall financial health like bank account balances, outstanding mortgage principal, and cash distributed to owners.
A complete record-keeping system should be capable of producing a balance sheet; it is one of the three core reports in accounting.
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How do I set up a balance sheet for my rental properties?
Your balance sheet includes all asset, liability, and equity accounts from your chart of accounts (see: the chart of accounts for rental property). Asset accounts go on the left side of a balance sheet and liabilities and equity are on the right. The two sides will balance according to the rule Assets = Liabilities + Owner’s Equity. This equation is the basis for modern accounting and is often called simply “the accounting equation”.
What is the difference between owner’s equity on the balance sheet and the market value of my equity?
When real estate investors say “equity”, they are typically referring to the market value of their properties minus loans outstanding – not owner’s equity on the balance sheet.
The balance sheet shows the book value of your business assets at a particular point in time, as well as how they have been financed through a combination of liabilities and owner equity. However, in real estate this picture can be incomplete. Properties are added to the balance sheet at cost when they are purchased and only change value via depreciation expenses and capital improvements. The book value and market value of an asset (and its associated equity) will generally start out the same but gradually grow more and more different the longer an asset is held. Price appreciation due to market conditions is not included on the balance sheet, and the book value of properties generally declines year over year due to depreciation expenses- potentially even reaching $0 at the end of their IRS-determined useful life.
Tracking the book value of assets is necessary for depreciation and capital gains calculations, but REI Hub’s Portfolio Value by Property report can provide better information on the current market value of your assets and the equity which you could cash-out if you were to liquidate your portfolio. Using the market value of your equity is a better lens for how real estate is contributing to your net worth and for calculating the rates of return which your investments are generating.
Adding real estate to the balance sheet
When you purchase a property, you add it to your balance sheet. The exact journal will be determined by you or your financial professional based on your closing statement and several common steps:
- The property’s tax assessment is used to determine the percent of the purchase price to be allocated to land versus buildings, each of which is debited on a journal line. This allocation is important because, tax-wise, land does not depreciate; buildings do.
- Certain closing costs are also added to your basis with a debit to capitalized closing costs.
- Additional closing costs may be debited as expenses flowing through to the P&L.
- The starting loan balance is set with a credit if you’ve obtained financing for your purchase
- The cash due at closing is either credited to a bank account or an owner contribution.
Conclusion: Your balance sheet is important but doesn’t show your market equity
Your balance sheet tracks important financial information about your business – particularly for your tax records. It provides you with a snapshot of the book value of tangible assets and the balances of your bank and loan accounts at a given point in time. While important, for real estate investors it typically receives less attention than the net income report or statement of cash flows because real estate assets and owner’s equity on a balance sheet do not accurately represent the current market value of your portfolio. For those, you’ll want to look at a portfolio value report to see your current worth. Use the links below to learn what makes REI Hub the best accounting software for rental property owners, and thanks for reading!
