Can You Speak Lender?
By: Matthew Hausman, CPA
Today more than ever, as a result of the Tax Cuts and Jobs Act, privately held real estate owners and operators are income tax basis driven and focused. Meanwhile, lender and financial institutions still live in the world of generally acceptable accounting principles (GAAP). Understanding the disconnect between the income tax basis of accounting (ITBA) and GAAP is crucial when structuring loan agreements and negotiating with lenders and financial institutions, as it can ultimately help achieve a better end result. The following are the key differences between GAAP and ITBA that can have significant impact on restrictive covenants (e.g., debt service coverage ratio (DSCR), independent audit requirements and periodic financial reporting by management to lenders).
- Rental Income – Under GAAP, rental income is recognized on a straight-line basis over the terms of the leases. Straight-line basis rental income calculations can be time-consuming, costly and create undue pressure on your back office. However, under the ITBA, rental income is recorded on an accrual basis for amounts earned under the lease. In addition, under the ITBA, prepaid rent is included in rental income during the year it is received. ITBA reporting requirements can alleviate such concerns, paint a more accurate picture of your operation and potentially provide a more achievable DSCR for a growing real estate operation.
- Avoid Unnecessary Costs – Under GAAP, a portion of the purchase price of a real estate acquisition should be allocated to tangible and identifiable intangible assets and liabilities at their relative fair value. Under the ITBA, no such intangible assets are recognized. As a purchase price allocation report/analysis can be costly, negotiating an ITBA reporting requirement will result in a quick increase to your bottom line.
- Tangible Property Regulations – Under the ITBA, the Tangible Property Regulation (“Regulation”) issued by the Internal Revenue Service became effective January 1, 2014. As defined by the Regulation, expenditures incurred for the betterment, restoration, or adaptation of a unit of property to a new or different use are capitalized. All other expenditures to a unit of property that do not fit this description are treated as routine repairs and maintenance items and deducted in the period incurred. Under GAAP, many such expenditures for repairs and maintenance (i.e., those that create probable future economic benefit) are capitalized and depreciated over their estimated useful life. Understanding and communicating this significant difference between ITBA and GAAP with lenders is crucial. Under the ITBA, as a result of the Regulation, at times, millions of dollars of items that are of “capital improvement” nature can be expensed resulting in a meaningful impact on the bottom line and DSCR computations. When structuring your next loan agreement, taking the route of ITBA reporting with a special carveout in the definition of operating expenses would mitigate any negative impact the Regulation would have on your DSCR measurement.
- Other Differences – GAAP and ITBA also differ in the areas of accounts receivable (allowance method vs direct write off), impairment of long-lived assets (not applicable under the ITBA), derivative instruments (i.e interest rate caps and swaps, which are not recognized under the ITBA), start-up and syndication costs (capitalized under the ITBA and generally expensed under GAAP) and depreciation (based on the internal revenue code for the ITBA rather than estimated useful life under GAAP).
Understanding these key differences in the accounting methods can prove to be a critical tool when negotiating with lenders and financial institutions. Capitalizing on your new-found knowledge of these differences can release undue reporting requirement pressure on your back office and, most importantly, increase your bottom line! Remember: it is important to educate your investors, lenders and financial institutions as they still maybe stuck in the world of GAAP.
The Real Estate Group at Marks Paneth is here to help if you have further questions on this critical topic!