Beefing up your bottom line in a competitive real estate environment requires an effective tax planning strategy. And the tax accounting method you use can play a key role.
Generally there are two methods available for real estate activities: cash and accrual. These methods differ in several ways, including how income and expenses are reported on your tax return. By selecting the method that works best for your enterprise, you could see some significant tax benefits.
What’s the Difference?
Under the cash accounting method, income becomes taxable when payment is received. Expenses are deductible when actually paid instead of when an invoice is received from a vendor.
The accrual method, on the other hand, recognizes income when earned regardless of when the payment is received. This would occur when, for example, a service is performed or a product is received by the customer.
One important exception to the accrual accounting method is the recognition of prepaid rents. Property owners must recognize these payments as income when received, regardless of the selected method of accounting.
Which is Better?
The accounting method you choose should depend upon your business needs. The main advantage of the cash method is its simplicity. It closely follows the inflows and outflows of cash in your business. At tax time, you don’t have to pay taxes on any money that has not yet been received. This in turn helps you manage cash flows.
Additionally, the cash method may allow business owners to delay receipt of revenues and accelerate the payment of expenses before year end. This in turn effectively reduces taxable income. For example, a real estate agent working a deal at year end might choose to set the closing date for Jan. 2 rather than Dec. 30 to push the commission income to the following year.
Opponents of the cash method, however, cite that it doesn’t paint an accurate picture when it comes to the financial performance of your business. This is because it does not take into consideration accounts receivable and payable. The cash method is essentially a snapshot of the current cash position. It does not reflect business performance over a specified time period.
The accrual method attempts to follow the underlying economic transaction (rather than the flow of cash) and match expenses to generated revenues. For that reason, many banks and investors prefer that the accrual method is used when preparing financial statements. So if you are growing your real estate portfolio and looking for financing either from a bank or another investor, you may be asked to produce accrual basis financial statements.
An Unexpected Twist
Surprisingly, your business is allowed to use one accounting method for preparing financial statements and a different one for filing tax returns. For example, let’s say the accrual method is required by a creditor or investor. You can prepare accrual basis financial statements while using the cash method when filing your tax return. You don’t even have to keep two sets of books! A skilled CPA can convert accrual basis financials to cash basis at tax time.
The Tax Cuts and Jobs Act of 2017 (TCJA) expanded the availability of this method to many taxpayers. Most real estate business would likely benefit from using a cash method of accounting for tax purposes. However, the choice of accounting method is unique to each business and should be evaluated on an individual basis.
Additionally, while cash and accrual are the two primary tax accounting methods, they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.
Although the accounting method is usually selected on the initial tax return of the business, you can apply to change it. Generally, cash method is preferable if your accounts receivable and prepaid expenses exceed your accounts payable and accrued expenses. The year of the method change should bring great tax savings and improve cash flows.
Considering a Change?
A great deal of thought should go into weighing the pros and cons of tax accounting methods. So it’s best to consult with a CPA firm that knows the tax laws and the real estate industry. James Moore’s Real Estate Services team has decades of experience with these and other tax savings strategies. See how we can help you leverage them to your advantage.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.