The three main reasons for investing in real estate are the potential for monthly income, appreciation in property value over the long term, and tax benefits from real estate deductions.
A good real estate accounting system can help investors find ways to grow cash flow, keep track of every tax deductible expense, and comply with local and federal legal and tax requirements.
In this article, we’ll discuss how accounting in real estate works and explain how to set up and automate a real estate accounting system.
- Real estate accounting helps investors to track income and expenses, increase net income, and manage debt better.
- Two functions of real estate accounting are bookkeeping and backup.
- Steps to set up a real estate accounting system include selecting an accounting method, using business banking accounts, creating a chart of accounts, and reconciling bank statements.
What is accounting in real estate?
All businesses use an accounting system to keep track of income and expenses and resulting profits or losses, and real estate investing is no exception.
Having a real estate accounting system in place makes it easier for an investor to make better investment decisions by knowing the financial position of each property at any given point in time.
Track income and expenses
Accurately keeping track of monthly rental income and operating expenses makes it easier to understand the profit (or loss) that each property generates and why.
Real estate accounting also makes it easier to comply with legal and tax requirements such as not commingling a tenant security deposit and timely collecting and remitting any monthly rental tax required by local and state laws.
Increase net income
Knowing the exact amount of each receipt and payment that flows into and out of a rental property can also help an investor to identify opportunities to grow net income by incrementally increasing income or decreasing operating expenses.
For example, a tenant rent payment recorded after the first of the month may mean that a late fee could be charged. Or, an unusual increase in landscaping expenses one month might mean that the vendor accidentally sent the same invoice twice.
Manage debt better
Many investors view the additional net income gained by effectively managing income and expenses as “found money” that can be used to pay down mortgage debt faster to more quickly increase owner equity.
The Stessa Balance Sheet feature periodically updates property value based on the current market conditions and keeps track of property debt in real time by linking to an investor’s mortgage account.
Having a more accurate idea of the current equity in a property can make it easier for an investor to decide if the time is right to refinance or to pull cash out of one rental property to use as a down payment for another.
Main parts of a real estate accounting system
There are two main components in a real estate accounting system to understand:
Books of the real estate business record all of the money flowing in and out of each rental property, down to the last penny.
A real estate bookkeeping system can come in different forms, including a traditional spreadsheet that requires manual updating or a rental property financial management system like Stessa that automates income and expense tracking.
A paper trail provides a backup and supporting documents, such as bank statements and vendor invoices, to prove that income and expenses recorded are true and accurate.
Some investors use a filing cabinet to store real estate documents, others scan and upload paperwork to a public system like Google Drive. Today, many real estate investors are embracing property technology by signing up for a free account with Stessa.
After linking property and banking information, expenses can be tracked on the go with the iOS and Android smartphone apps to create a paper trail with backup stored securely in the cloud.
How to set up a real estate accounting system
With bookkeeping and backup in mind, let’s look at some of the things to consider and steps to follow to set up a real estate accounting system for a rental property business.
An accounting method is a set of rules used to determine when and how income and expenses are reported, according to IRS Publication 538, Accounting Periods and Methods. Accounting methods in real estate include the cash method, the accrual method, or a combination of both.
Real estate investors are not required to use any single accounting method.
However, they must use a system that clearly reflects income and expenses, maintain permanent accounting books, and have backup to support entries made in the accounting system and tax returns. The same accounting method must also be used from year to year. To change the accounting method, an investor must get IRS approval.
The IRS reports that most individuals and small businesses use the cash method of accounting. Under the cash method, income such as a tenant rent payment is reported when it is received, and expenses are reported when they are paid (not when the invoice is received).
Personal vs. business banking
Commingling in real estate occurs when money that belongs to one party is mixed with funds from another.
Depositing a tenant security deposit in a property owner’s general operating account is an example of commingling, as is using the same bank account for business and personal income and expenses.
Combining business and personal funds makes bookkeeping more difficult. It may also create legal problems if a tenant’s security deposit is used to pay personal or business expenses of the owner, and create potential tax issues if income and expenses are accidentally under or over reported.
Before collecting the first rent payment or paying the first bill, real estate investors set up a business checking account, savings account (for CapEx or tenant deposits), and credit cards to keep business expenses separate from personal expenses.
Chart of accounts
A chart of accounts is the place where rental property income, expenses, assets, and liabilities are reported. According to the National Association of Residential Property Managers (NARPM), a chart of accounts for real estate includes:
- Checking account
- Savings account
- Reimbursable expense to owner
- Utility deposit paid to open a new account
- Rental property value
- Accumulated depreciation
- Credit card
- Tenant security deposit (refundable)
- Loan from shareholder (such as the member of an LLC)
- Mortgage loan
- Owner contributions
- Owner distributions
- Retained earnings
- Net income
- Owner equity
- Tenant monthly rent payment
- Additional rent (such as pet or appliance rent)
- Other income (including tenant application fees or late fees)
- Bad debt expense (NSF check from tenant)
- Property management
- Repairs and maintenance
- Mortgage interest
- Property taxes
- HOA dues and fees
- Utilities (sometimes paid by the landlord in a small multifamily property)
Each time a transaction is made, such as a tenant security deposit received, a tenant rent payment made, or a vendor invoice paid, the transaction is recorded or booked to a specific line item in a chart of accounts.
Transactions posted to the chart of accounts are pulled to create financial reports such as an income statement, balance sheet, or net cash flow statement.
Income and expenses
A good real estate accounting system categorizes income and expenses based on IRS Schedule E (Form 1040), Supplemental Income and Loss. While every rental property is different, some common rental property income and expenses include:
- Rental income
- Additional rental income (such as pet or appliance rent)
- Other income
- Bad debt expense
- Property management
- Advertising & marketing
- Leasing commissions
- Repairs and maintenance
- Property taxes
- Mortgage interest
- Licenses & permits
- Capital improvements (CapEx, such as installing new carpeting or replacing the HVAC)
Bank account reconciliation
A real estate accounting system reports what income and expenses should be, while the monthly bank account statement shows money that was actually received or spent. Ideally, the information in a real estate accounting system should match up or reconcile exactly with the monthly bank statement.
On a macro level, a monthly bank account reconciliation starts with an opening balance and ends with a closing balance. The variance between the two amounts is the difference between income received and bills paid.
Sometimes income and expense items on a real estate accounting system don’t match up exactly with what the bank statement shows.
For example, a vendor payment made on the last day of the month will show up as an expense in the real estate accounting system right away, but probably won’t be posted to the business checking account until the following month.
Generate financial reports
Real estate financial reports including income statements, balance sheets, net cash flow statements, and capital expense reports, pull data from the real estate accounting system and present information to an investor in different ways:
- Income statements (also known as a profit and loss statements) break down the income and expenses of a rental property and report the net income generated.
- Real estate balance sheets summarize all of the asset, liabilities, and equity of a rental property at a given point in time.
- Net cash flow statements are used to monitor inflows and outflows of money over a fixed period of time, normally monthly and annually.
- Capital expense reports track money used to add value to or improve a rental property beyond common repairs and maintenance, such as installing new appliances or replacing an old roof.
Make real estate accounting simple
Real estate accounting can be complex, but it doesn’t have to be that way.
That’s why Stessa was created. Stessa’s platform automates income and expense tracking, helping real estate investors to maximize profits through smart money management. Rental property performance for single-family homes, multifamily buildings, and short-term rentals can be tracked at the property and portfolio level via the online dashboard.
After signing up for a free account with Stessa, real estate investors simply enter the property address, connect bank and mortgage accounts quickly and securely, and run informative financial reports.
Best of all, investors receive personalized recommendations and custom alerts to help manage and grow a rental property portfolio with confidence. It’s real estate accounting software made simple.