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Why Real Estate Companies Should Consider Income Tax Basis Accounting for Financial Statements

By: Jonathan Lovell

While it’s not necessarily a secret, there may be some real estate companies that aren’t aware that there’s an alternative to GAAP (Generally Accepted Accounting Principles) for maintaining their accounting records and presenting their financial statements. The accrual-based income tax basis of accounting is an acceptable alternative to GAAP for real estate companies.

If income tax basis accounting is the right fit for your company, it could save you time and money when it comes to year-end reporting. Let’s take a closer look at the upside of the income tax basis accounting method.

Why Would a Company Want to Use the Income Tax Basis of Accounting?

First, it is less complex than GAAP, which means less time spent on internal accounting and less time spent by your independent CPAs at the end of the year. There are certain rules in GAAP that require significant time to implement, maintain and report on that would not be required under the income tax basis of accounting.

Another reason to choose the income tax basis of reporting is that your records would be on the same basis for your financial statements and your tax returns. This means you won’t have to spend time maintaining two different sets of books and records.

Your economic results may also be more clearly understood by the actual users of your financial statements, like your lenders, under the income tax basis method. There are differences between the two methods, explained further below, that result in the income tax basis generally showing results that align more closely with the mindset of cash flow analysis and tax implications that are at the forefront in many real estate companies. For example, the actual cash flow from leases during the reporting period would be shown on the financial statements.

Key Differences Between the Two Methods

Rental Income & Prepaid Rent — Under GAAP, rental income and expense are generally recognized evenly over the term of the respective leases, including leases that contain rent step-ups or concessions (straight-line rent). Rent paid in advance is accrued as deferred revenue on the balance sheet. Income tax basis accounting simply calls for rent and expenses to be recorded in the period received or paid. If received in advance, the rent is reported as income, which better matches with the activity during the year.

Depreciation — Assets are depreciated over periods determined by the Internal Revenue Code (IRC) instead of estimated useful lives under GAAP. This treatment allows management to more easily evaluate the tax advantages inherent as a real estate entity as well as making it easier to estimate the taxable gains on a sale.

Start-up / Organization Costs — These costs can be capitalized as prescribed by the IRC, whereas under GAAP they would be expensed.

Impairment Analysis — This is required under GAAP if certain triggering indicators are met, which can be a costly analysis involving outside appraisers. This analysis is not required under the income tax basis method of accounting, and any write-down in value is typically only recognized upon the sale of the asset.

Variable Interest Entities — Variable interest entities may not be required to be consolidated under the income tax basis method; however, disclosures like those required under GAAP would likely still be needed.

Financial Statements — There are various disclosures that are required under GAAP that are not required when reporting your financial statements on the income tax basis of accounting. Some examples of additional GAAP requirements are disclosing the fair value of certain assets and liabilities, evaluating contracts for revenue recognition and additional requirements for lease accounting. The income tax basis method reduces the burden of labor-intensive recordkeeping and reporting requirements.

Could My Company Use the Income Tax Basis Accounting Method?

The answer, of course, is it depends.

Publicly traded companies are required to report on a GAAP basis, and companies with institutional investors will likely also require GAAP reporting. If your reporting requirements are not dictated by a regulatory or governing body, you may be able to benefit from reporting on the income tax basis accounting method.

Your lenders may be more willing to accept income tax basis financials than you think. They are likely to have a better understanding of the income tax basis than they will of certain complex GAAP reporting requirements. Often, it is just a matter of asking your lender the question. Part of this conversation should include evaluating whether any covenants need to be revised to ensure they remain in good standing.

The key consideration is to have a good understanding of what the end users of your financial statements need, and whether reporting on the income tax basis of accounting will deliver on those needs.

Need Help?

If you’d like help determining whether the income tax basis accounting method is right for your business, contact us here or call 800.899.4623.

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Published February 11, 2021

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