GAAP vs. Tax: Considerations for Loan Reporting of Real Estate Entities
October 05, 2020
By Paul Dolinshek
Entering into a loan agreement can certainly be a daunting task. But it is imperative to take the time to carefully consider the differences between GAAP and tax basis before executing a loan agreement. This decision could have a profound impact, such as on time and money, on the borrowing entity.
In addition to submitting annual financial statements to the lender, real estate loans often contain covenants, typically loan-to-value, debt service coverage ratio and debt yield. It is important to understand how the basis of accounting components affect these ratios.
Whether an entity reports under GAAP or tax basis of accounting, the principal balance, debt service and fair value of the property will generally be the same. There may, however, be significant differences in net operating income (“NOI”) due to differences in revenue recognition. Whether or not this impacts the loan reporting depends on the language in the loan agreement. Generally, the lender will define NOI, regardless of the basis of accounting.
Here are some pros and cons of GAAP and of tax basis:
|Most common||Additional costs||Single set of books||Unfamiliarity by bankers|
|Comparable to public companies||Book to tax adjustments||Revenue approximates rental payment schedule (no straight-lining or above/below market adjustments)||Financial reporting standards may appear obtuse|
The basis of accounting can be easy to overlook in the loan application process, but it can have a significant impact to the entity regarding time and cost. The company needs to assess all relevant factors, speak with its trusted business advisors, and choose what best fits their needs. Ensuring that the company and its lender have the same understanding is crucial to a successful lending relationship.