What’s the Best Basis of Accounting for Your Real Estate Company?
- Published
- Feb 28, 2024
- By
- Donna Fleres
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Real estate companies need to understand the differences in accounting principles generally accepted in the U.S. (“GAAP”) and the income tax basis of accounting. Both are common methods of accounting for real estate entities, but owners should understand the options and choose which is best for their companies.
Comparing GAAP and Income Tax Basis for Real Estate Accounting
Public companies, such as a publicly traded or public non-traded real estate investment trust (“REIT”), are required to use GAAP reporting. Privately held companies may be required by their financial institutions to use GAAP reporting. When an entity’s accounting method is not dictated by their lender or a governing body, the entity should consider which basis is a better financial management tool and what the impact of the basis on the company’s financial results and presentation will be.
The differences between GAAP and the income tax basis of accounting are highlighted below.
| Topic | GAAP | Income Tax Basis |
|---|---|---|
| Depreciation | Requires that buildings and improvements be depreciated over their estimated useful lives. |
The recording of depreciation is done over the lives prescribed by the Internal Revenue Code ("IRC"). The IRC may provide accelerated depreciation deductions for certain assets that do not exist for GAAP. |
| Impairment | Assets are initially recorded at fair value (for a business combination) and relative fair value (for an asset acquisition) based on the purchase price and subject to impairment testing. | Property and equipment are recorded at historical cost based on purchase price and not subject to impairment testing. |
| Purchase accounting- intangible assets | The purchase price of real estate is allocated to the fair value (or relative fair value for asset acquisitions) of the acquired tangible and intangible assets, land, building, tenant improvements, above and below market leases, origination costs, acquired in-place leases and other identified intangible assets. | The purchase price of real estate is allocated primarily to tangible assets, and typically excludes recording intangible assets upon acquisition. |
| Revenue | Revenue is recorded only when earned. Rental revenue is recognized on a straight-line basis over the life of the lease, which results in the same amount of rent being recognized each month of the lease agreement, regardless of the amount the tenant is actually billed. Rent holidays, abatement periods, and escalations are all generally considered in the straight-line calculation. |
Revenue is recorded at the earlier of when received or earned. Revenue primarily represents the cash received and the effect of scheduled tenant rent increases and allowances is ignored. Note however there are special revenue recognition rules for certain types of leases (i.e., “467 leases”).
|
| Bad Debts | Requires the Company to discontinue recognizing revenue once it is determined to be uncollectible. | A company utilizes the direct write-off method to account for bad debts. |
| Prepaid Rents | If revenue was received in advance of its due date, a company would record deferred revenue on its balance sheet (a liability account) until earned under the terms of the lease agreement. |
The rent is recorded as revenue in the period it is received. Note however there are special revenue recognition rules for certain types of leases (i.e., “467 leases”).
|
| Variable Interest Entities (VIEs) | An entity must evaluate each commonly controlled entity and determine whether it is a VIE and then consider whether it is required to be consolidated with the reporting entity. |
Does not require evaluation or consolidation of variable interest entities.
|
| Leases (for lessee) | The Company would present as a lessee their leases with a right-of-use asset and offsetting liability. | Does not require recording leases on the balance sheet. |
| Interest rate caps and swaps | Recognized as either assets or liabilities in the balance sheet and measured at fair value. | Cap / swap acquisition costs are amortized over the term of the interest rate cap or swap agreement. |
| Investments in partnerships | Investments may be measured at cost, and adjusted for observable price changes and impairments, if any. Under the equity method, an investment is initially recorded at cost and subsequently adjusted for equity in net income or loss and cash contributions and distributions. | Under the equity method, the taxpayer records an initial investment at cost and thereafter increases its investment for its share of allocable income from the investment in partnership and any additional cash investment / contributions. The taxpayer decreases the investment in partnership for its share of allocable losses and distributions received from the investment in partnership. |
| Investments- marketable securities | Marketable securities are generally accounted for at fair value, while recognizing unrealized gains and losses. | Marketable securities are recorded at cost. Gains and losses on marketable securities are not recognized until the securities are sold. |
| Expenses | Certain items may be capitalizable. | Certain items are able to be expensed as repairs and maintenance. |
How to Choose Between GAAP and Income Tax Basis in Real Estate Accounting
Reporting under the GAAP basis or income tax basis of accounting each has its pros and cons, which will vary by entity. The bottom line is real estate companies should consult with their accountants and business advisors to better navigate the benefits, complexities and nuances of both U.S. GAAP and the income tax basis of accounting to select the most appropriate basis of accounting to meet their needs.
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Donna Fleres
Donna Fleres has over 15 years in public accounting assisting companies with SEC reporting and managing audits in accordance with Public Company Accounting Oversight Board standards.
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