Real estate investors can keep their books using the cash-basis or accrual-basis accounting method to recognize their income and expenses on their tax returns. However, most landlords use the cash-basis method. That’s why REI Hub accounts use the cash-basis method as the default setting! In this post, we’ll review the basics of cash and accrual accounting, the tax benefits of using the cash-basis method for rental properties, and the best practices for cash accounting.
The Differences between Cash and Accrual Accounting for Rental Property
Cash Accounting
In cash-basis accounting, you’ll record a transaction when money is exchanged. With this method, you’ll record the rent payment when your tenant pays you. If your tenant misses a payment, your income statement won’t show a rent payment for that month, even though the tenant owes you rent. If your gas bill covers two months’ worth of gas, you’ll recognize the entire expense when you pay the invoice.
The downside of cash accounting is that rental property expenses can vary from month to month. A single month might not reflect what a property’s average expenses should be. If you have an extra repair or if you forget to pay an invoice, you’ll over- or understate your cash flow for the month.
However, the cash-basis method is a straightforward process. It lets you track your cash flow position easily in the moment, particularly if you use a separate bank account for your rentals. You don’t need a background in accounting to understand or use cash accounting, which makes it a popular choice for sole proprietorships and small businesses.
Accrual Accounting
With the accrual method, you recognize income and expenses when they are earned or incurred, independently of when you exchange funds for the transaction. For example, you’ll record rental income for the month, even if your tenant is late paying. If you pay your insurance premium yearly, you’ll still create monthly expenses so that the cost is spread out evenly over the year.
This method requires more tracking but has several advantages. Accrual-based reports can better represent a business’s financial activities, particularly if the business has substantial inventories, prepaid expenses, or overdue (but collectible) invoices. Managers, owners, and investors can clearly see the cash flow and profitability of a business through independent lenses because accrual-based reports show a more accurate picture of when a business’s income and expenses are incurred, even if there are timing differences with the related payments. The IRS requires businesses that maintain physical inventories to use the accrual basis.
The other main advantage of accrual accounting is claiming depreciation expenses. In pure cashed based accounting, depreciation does not exist since there is no corresponding cash outlay for the expense. Fortunately, the IRS actually recognizes a modified cash basis system for real estate. This allows investors to claim depreciation under either the cash or accrual basis, equalizing one of the main advantages of accrual method accounting.
Accrual accounting is more time consuming, but this method can produce a more meaningful income statement. However, to understand the business’s cash position, you’ll need a cash flow statement, a balance sheet, and a solid understanding of accounting principles as well.
Tax Benefits of Using Cash Accounting for Real Estate Investing
Aside from its simplicity, the cash-basis accounting method is also popular because it has tax benefits. Using cash accounting gives you more granular control of your taxable income within a time period. With cash accounting, you can manage your reported income by paying off more expenses within a period. For example, say a rental property owner is over their planned income bracket for the year. They may want to pay off some expenses early to lower their tax liability for the year. The cash-basis method offers that flexibility, making this method a good option for rental property owners.
Cash Accounting Best Practices
No matter which account method you choose, remember that using that method consistently is key. The IRS recognizes whichever method you use to first file your taxes. That means if you start out with cash-basis accounting to file your taxes, you must keep using that method. To change methods, you’ll have to get IRS approval first.
Under the cash method, you must include all items that you actually received or constructively received during the tax year in your gross income. With constructive receipts, you’ll count funds as income when you or your agent has control over the funds, even if you don’t necessarily have possession of it. So if your rental property has a property manager, your tenant may give their rent payment to the property manager who acts on your behalf. That payment should be reported as income when your property manager receives the payment, not when the deposit clears your bank account.
And remember, if your tenants offer goods or services instead of rent, you must include the fair market value of those goods or services in your reported income. Do you receive advance rent payments? If a tenant pays rent before the period that the rent covers, include the advance payment in your rental income for the year you receive the payment.
Security deposits that you plan to return to the tenant at the end of their lease don’t count as income. However, ff the deposit counts as the last month’s rent (an advance payment), report the security deposit as income. If you keep all or part of the security deposit because of tenant damage, the funds that you keep from the deposit will count as reportable income.
Should Real Estate Investors Use Cash or Accrual Accounting
The cash and accrual accounting methods both offer benefits for real estate investors. Talk with your accountant or tax preparer to see if one method is more advantageous for your rental property business. Are you comfortable working with cash flow statements? Do you have the time to spend on more involved bookkeeping? If not, the cash-basis method is likely the better option for you.
The simple bookkeeping steps, easy-to-understand reports, and tax benefits of cash accounting make it the most popular choice for rental property owners.
