Real Estate Financial Statements: One Size Does Not Fit AllBy Neil A. Sonenberg | Darya Shneyder | July 27, 2018
When a company is in need of an annual financial statement, a Generally Accepted Accounting Principles (GAAP) financial statement is typically the first thing that comes to mind. However, unless there are regulatory requirements, such as Real Estate Investment Trusts (REITs) or companies that rely on public investment, a GAAP financial statement is not the only option. Many companies that invest in real estate are opting for a special purpose – income tax basis financial statement instead.
WHAT’S THE DIFFERENCE?
In simplest terms, the GAAP basis attempts to provide consistency in reporting between all industries, while the income tax basis focuses on reporting the correct taxable income. Determining the best choice of financial statement for your real estate company requires a deeper understanding of each financial statement type, the needs of your financial statement’s end user, and the lending requirements of your financial institution.
COMPARING GAAP AND INCOME TAX BASIS FINANCIAL STATEMENTS
GAAP financial statements follow standards and practices prescribed by the Financial Accounting Standards Board (FASB), making them more uniform in nature to other similar industry financials. The IRS maintains and develops the tax accounting framework with the intention to levy tax on taxable income or net earnings.
Unlike GAAP financial statements, which are structured to fulfill a certain mold and ensure standardization between all financial statements within an industry, tax basis financial statements are designed to make the information less complex and easier to understand.
The following examples point out specific differences between the two financial statements within the real estate industry:
- Rent -To be in compliance with GAAP, the rent received from a lease is required to be straight-lined over the entire life of the lease, and should include all of the “free rent” (rent holiday) that is often provided to entice tenants. The straight-lining of the rent leads to a consistent rent expense recorded over the life of the lease, which has a balance sheet impact on the financial statement.
On a tax basis financial statement, the rent would normally be lower in the beginning of the lease period until the rent escalations take place. Additionally, the concept of prepaid rent (which is an asset on the balance sheet of the GAAP financial statement) would not exist on the tax basis financial statement. Income is taxed when it is received, as opposed to when it is earned.
- Depreciation – This is another area that provides contrast between GAAP income and taxable income. For example, depreciation on a leasehold improvement on the GAAP basis financial statement is calculated over the life of the tenant’s lease. Under income tax basis, depreciation for a leasehold improvement is recorded over a 15-year life, with the possibility of bonus depreciation.
- Allowance for doubtful accounts –Another difference between the two financial statements involves the allowance for doubtful accounts. A GAAP financial statement requires an allowance to be set up against “old” accounts receivable, whereas a tax basis statement requires a direct write-off when a receivable is deemed uncollectible.
- Mortgage with SWAP interest – Currently, in order to hedge interest rate risk, corporations are sometimes opting to obtain a mortgage with an interest rate SWAP agreement. Due to the nature of this transaction, a GAAP financial statement involves recording a fair value adjustment for the SWAP option, which affects both the balance sheet and the income statement. Since the fair value adjustment concept does not apply to the tax basis of accounting, this adjustment would not be made, and only the interest that has been paid/ accrued to the mortgage holder would appear on the statement of revenues and expenses.
CHOOSING THE RIGHT FINANCIAL STATEMENT
The decision to determine the appropriate basis of your company’s financial statement should be based primarily on the users of the financial statement. In the real estate industry, these users are generally shareholders/members and lenders. To shareholders, the disclosure requirements and book adjustments to be in compliance with GAAP are often overwhelming and in excess of what is necessary.
For lending purposes, most banks will readily accept a special purpose - income tax basis financial statement to fulfill lending requirements. Discussions should be held with lenders prior to completing the refinancing or loan documentation to understand what is expected.
Many real estate investors choose tax basis financial statements for their own benefit as well. They appreciate the consistency between their tax return and the financial statement, eliminating the need to disclose on a tax return a reconciliation of differences from book income to taxable income.
Regulatory requirements may necessitate the use of GAAP financial statements, so it’s important to understand the compliance environment of your particular sub-sector of the real estate market.
PUTTING YOUR FINANCIAL STATEMENT TO WORK FOR YOU
Before, during and after the audit, it’s important to know what steps to take to get the most out of the numbers on a financial statement. Determining the basis of the financials is only the first step.
Once the choice has been made, seek guidance from your auditor on how to use the financial statement to generate helpful information for your company, such as assessing internal controls, uncovering additional revenue streams, and even detecting fraud and tax savings opportunities.
About Neil A. Sonenberg
Neil A. Sonenberg, CPA, is a Partner in Marks Paneth’s Real Estate Group. With almost 40 years in public accounting, Mr. Sonenberg excels in a wide range of tax and accounting disciplines. His “out of the box” thinking and passion provide clients with an array of planning opportunities to maximize both tax savings and profits. Sonenberg possesses expertise in all areas of real estate with knowledge expanding into wholesale and retail manufacturing as well as... READ MORE +
About Darya Shneyder
Darya Shneyder, CPA, is a Partner in the Real Estate Group at Marks Paneth LLP. Ms. Shneyder specializes in providing accounting, auditing, tax and advisory services to commercial and residential real estate owners, developers and co-ops and condominiums. She also specializes in securing real estate tax reduction via certiorari audit filings. With more than 13 years of experience in public accounting, Ms. Shneyder’s background also includes audit and tax services for the manufacturing and distribution... READ MORE +