Real Estate Accounting

In December 2020 and January 2021, my CPA of 18 years and I had a HUGE blow out.

When you see what he said, your jaw is going to hit the floor. When you see what I said back, it'll probably drop a little more unless you are used to my writings, in which case you may just add it to the pile.

This is an email from me to my new CPA on 3/14/2021 might help with some insight...

Editors Note: The actual email was much shorter. It conveyed this information but in summary format. I used that email as an outline to build out this better explanation of what I had been experiencing for the past 23 years or so...

Hey

Just wanted to let you know my docs for my returns are in fact coming. Hopefully in the next 24-48 hours. I'm writing this information below more so for my own clarity and documentation than yours but I figured if you have time to review it, maybe you have some insight or comments...

== Schedule E's ==

For many years all I've sent in to my CPA for my rental properties was an "income statement-ish" report that aligned with a schedule E categories along with a Schedule E template filled in without depreciation.

In my income statement-ish report, there were no extra categories (accounts) separating capital expenses from traditional expense, so those had to be noted in handwriting.
When I wasn't sure how much or how little I should or could take from standard expenses and apply to capital expenses, it was scribbled in writing on the I/S and my version of the Schedule E may or may not have shown the adjustments with hand written notes.
I guess the goal was to create conversation with the notes and then have a dialogue but often times it was weeks or months later when my returns would come back to me and by that time I had forgotten about some of the trivial and non-trivial items that should have been discussed.

As I found out when reviewing some things middle of last year, sometimes my capital gains submissions got manipulated or omitted without proper dialogue. In reviewing my depreciation tables, for the past 15 years I can only assume what was omitted as a short term expense in fact made it onto those tables. I also found simple typos had been made by either me and/or my CPA, and I found several examples of over and under reporting in more than one place.

The systems I had for reporting were better than most, but as is evident from this sharing, they still left huge amount to be desired and they were as reliable as Swiss Cheese.

With this current system of reporting for Schedule E to a CPA, the accountant ended up with very important year over year reporting in his system that I needed, and without making those adjustments in my own system, I was without the information I needed for all kinds of managerial accounting needs.

In fact, it was this problem that lead me to create my first Quickbooks substitute solution in 2002 and then things sped up so fast as they started moving the cheese around, I simply got lost.

At one point I had about 8-10 homes in various stages of construction or rental, two construction companies with over 10 employees, a technology consulting company, a personal life and one cat. Then the market tanked.

It was so frustrating feeling no control over my numbers, my businesses or my banking.

The small company bookkeeping was relatively simple compared to the rental and property development tracking. With regards to Rental Tracking, what I needed to have access to on a moment's notice with ease and clarity was and is:

Annual Taxable Income (historical, current, and projected)
Annual & Monthly Cash Flow Reporting for Cash Flow Management needs (historical, current, and projected)
Annual & Monthly Operating Income for Loan / Line of Credit Qualifying (historical, current, and projected)
Annual & Monthly Actual Income {referred to as a Made and Saved Reporting} to be sure being engaged in the property was worthwhile (historical, current, and projected)
A Sales Simulation Tool that uses theoretical Sales Transaction inputs and produces Net Sale, Capital Gains and Capital Gains Tax estimations in order to make informed sell/keep decisions

Ironically, none of these will come very easily from a list of categorized transactions as one would keep in the normal check and credit card statement Journaling process and the production of a faux-ish income statement.

Some of these reports require just one or two small adjustments to an income statement report
Others require special consideration and handling in the chart of accounts
Others require the ability to create year end general journal entries.

This gets complicated quick without a friendly and flexible bookkeeping software solution that can be customized specifically for small Real Estate Investor needs and Quickbooks most certainly doesn't fit that bill. Likewise, none of the non-double entry accounting systems like Quicken did either...

My first swing at a solution was a web based, fully database drive system. I got to the point hwere it was tracking transactions by property and creating some of the relevant reporting. I got it to where I could even make faux journal entries if I recall, but then I shifted to spreadsheets for other reporting until I could circle back and I never got those reports institutionalized properly.

Problems -

Because my Income Statement reporting was aligned with Schedule E items only, I was missing separate accounts for capitalized expenses. That forced that dialogue to be done in hand written notes or on reports. It also created a situation in which partial Expense Categorizations had to be made for capitalized items which can lead to more math errors.
Because I didn't make adjusting entries to separate principal out from mortgage payments, I had no reporting pre-configured for Housing Expenses, Operational Expenses and Net Operational Income which made talking quickly with lending and line of credit folks very cumbersome. This lack of adjusting entries is why I actually created my own Schedule E templates, as they served as an intermediate step to getting taxable income where I was manually splitting up aggregated mortgage payments.
Because I didn't track my own depreciation and make my own adjusting journ entries for those 1) I couldn't easily cross check my Schedule E Totals with my CPAs for an aggregated cross check and 2) I was always in the dark of total accumulated depreciation. The later left me fumbling to determine cost basis as it affected capital gains and capital gains tax estimates and profits when doing keep/sell analysis during property turnovers.
Because I had no cross check systems for my own typos when transferring data from my income statement-sh to my templated Sch E in a spreadsheet, errors were made several times resulting in under and over reporting. They were also made because I'd be done with all my reporting and then recategorize something in my accounting journals but not transfer that resulting shift to my version of the Schedule E.

It was all just such a mess. The majority of that mess starts with using Closed End Mortgages with amortizing payments and escrow accounts instead of simple Lines of Credit for financing, and then it expands out from there.

I decided to take this time while switching to you to try to get my systems up a level or two with these Schedule E's and rentals, and that's what i've been working on for the past few days.

I'm getting close to pleased with the new reporting. Just found something else I need to change, but getting close.

I'll get this to you as soon as I can get it all wrapped up.

thanks

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Ok no problem. I understand what you are trying to do.

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And with his simple response, I felt like I was on the right path.

These were the images attached to that email...

Properly Accounting for Rental Property (or your primary residence) is surprisingly complex when you have a "mortgage" with an amortizing payment and escrow account as opposed to a "line of credit".

Many new to bookkeeping for mortgages will initially think the single, consolidated payment is convenient and simple until they try to get relevant tax, financial. managerial and/or cost accounting reporting from their simple records. Those darn single payments intertwine too much together to make anything simple.

The amortizing payment and the escrow account is in fact a far larger benefit to the banker than it is the investor. These payment systems help Bankers:

Ensure the property taxes and insurance are paid to protect their own interest and
Aggregate float money they can use for collateral for "fractional reserve banking".

It's shocking for most who have a baseline accounting education when they realize everything in our mortgage based lending paradigm revolves far more around banker benefits than consumer benefits and it's even more shocking when you then realize the way our home lending industry revolves lopsidedly around mortgages as opposed to a far more healthy balance in other parts of the world. American Exceptionalism strikes again!

You have no idea the kind of real estate lending bubble you live in until you compare our mortgage and line of credit offerings to those found in the UK, Canada, Australia and New Zealand. The level of banker imprisonment in our systems would shock them all to no end.
The use of Lines of Credit for first position liens is extremely common in most other British Colonies, yet here in the US, I might as well be speaking Greek.
And admittedly I have no clue about Mainland Europe, Asia or most third world countries, but my guess is they are also going to have far more line of credit offerings, but I'll wait for others to provide that information for clarity.

With just a little education you'll quickly realize there's no easy way to get the proper info you need from a digital check register without 1) the use of the General Journal for adjusting entries and 2) a full double entry accounting system that would accompany such a journal. That said, you'll be shocked to realize a typical "income statement" is relatively useless in raw form for small business rentals and keeping a balance sheet for your rental business is extremely complex due to some odd transactions from time to time that won't make much sense from a categorization perspective without some coaching and/or a cheat sheet.

But most have no clue what i just said, and unfortunately getting to the point where you understand that doesn't get you close to remedied?!?

The reporting you will really need for your 1) taxable income 2) cash flow understanding 3) full income reporting (Made & Saved) and/or your 4) operational income needs all starts with income statement data, but then requires different modifications or manipulations to get that which is relevant to you or a relevant stake holder.

Ironically, once you get all of that done, you'll want/need about 4 different static and/or small data base driven reporting systems for loan applications, profit analysis and buy sell decision making with tax implications.

And THEN you will be content with your Bookkeeping for Residential Rentals.

YEP.

THIS is exactly what drove me to build my own accounting software in 2001 or so.
I'm only about 20 years late in getting a commercial version out with the education needed to help others come up to speed faster.
As it turns out, there were a lot of distractions and detours along the way.

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