When you think of investments, what comes to mind? Is it the stock market? What about real estate? Real estate has been a steady investment avenue for decades with the average return on investment lingering around 8.6%.
In addition, demand for real estate has never been higher with global shortages in the housing market. Despite the shortage pushing up purchase prices, there is still a significant profit margin for real estate investors.
Whether you are already a real estate investor or are looking to purchase your first property, understanding bookkeeping basics is vital to ensure your investment is producing the most return.
What is Real Estate Bookkeeping?
Real estate investors are running a business. This means that you must implement the right bookkeeping procedures just like any other business. However, the specific processes and procedures you follow differ from your local hardware store since the IRS requires you to report rentals in a specific way. Neglecting to have the proper accounting controls in place leads to stagnant business growth, lower profit margins, and filing inaccurate tax returns.
At the most basic level, real estate bookkeeping is the process of recording all transactions that your real estate investment incurs. This includes recording income, entering qualifying expenses, tracking asset values, and following loans. According to IRS Topic 414, most real estate businesses will operate on a cash basis of accounting, meaning income and expenses are not reported until cash clears the bank (IRS). Let’s break down each category:
- Income – Income includes rental payments from tenants, advance rent payments, expenses paid by the tenant, security deposits, and payments to cancel a lease.
- Expenses – To be an eligible expense, the transaction must occur in the normal course of business and be necessary. Some examples include depreciation, repair costs, cleaning fees, property taxes, professional fees, management fees, maintenance costs, and property insurance.
- Assets – Assets are everything your business owns. Each property you own will be listed as an asset along with cash and tenant receivables.
- Liabilities – Liabilities are everything your business owes, such as mortgages on your rental properties, management fees payable, and refundable security deposits.
Real estate bookkeeping also tracks equity, which is all the money you’ve earned or lost since you started your business. If you are the sole owner of the rental properties, this will be easier to manage since you don’t have to worry about tracking partner contributions. Keep in mind that this list isn’t comprehensive, meaning your business may see transactions outside of these items.
Who Benefits from Real Estate Bookkeeping?
Every investor that currently owns or is looking to buy can benefit from real estate bookkeeping. Buying a rental property comes with costs before you are able to sign on the dotted line. This includes earnest money, professional fees, and travel costs. In order to take each qualifying expense, you need to have your real estate bookkeeping system set up.
Additionally, both new and experienced real estate investors derive value from regular bookkeeping. Maybe you are considering selling one of your properties. What’s your breakeven point? Accurately tracking all transactions for each property is vital to generate a profit. If you have no idea how much money you have in the property, how can you decide on a price?
Moreover, when your real estate bookkeeping is completed with software automation, your transactions are stored for years, giving you the ability to go back and uncover past expenses to help you in the decision-making process. For new investors, an accounting software isn’t a resource you can forego. Not only do software programs provide guidance on recording transactions, but it also promotes accuracy.
Why is Bookkeeping Important for Real Estate Investors?
Bookkeeping is important for a variety of different reasons. Strong bookkeeping procedures will help you take advantage of each of these areas.
Maximize Income
Bookkeeping allows you to maximize your income and revenue. Too many real estate investors overlook opportunities to maximize income by making the assumption that rent is fixed. Other strategies to increase income include proactively renewing tenant leases to avoid vacancies, comparing rent prices to market prices, quickly qualifying tenants, adding features that increase rent, such as in-unit washing and drying machines, and allowing tenants to move in early with pro-rated rent. Each of these strategies can be utilized by having a detailed bookkeeping system.
Improve Cash Flow Management
When your bookkeeping is updated in real time, you are able to prioritize cash flow management. Cash flow management tracks the money flowing in and out of your bank account. Too much cash leaves potential investment opportunities on the table while too little cash increases your risk of bouncing payments. Tracking the money in your business bank accounts leads to more informed business decisions, such as saving up for a large repair or a down payment on a new property.
Reduce Expenses
There are only two ways to increase your profit: generate more income or reduce expenses. In order to find ways to reduce expenses, you need up-to-date financial statements, such as the income statement and balance sheet. Real estate investors can review the income statement for areas where they can cut costs. For example, maybe you forgot you were running electricity on an empty unit or noticed that you are subscribed to a newspaper that you don’t need. Finding these items is crucial to increase your net income and return on investment.
What are the Best Practices for Real Estate Bookkeeping?
The best practices you find most useful will differ between investors. At a minimum, you should have best practices outlined for opening, operating, and closing the books every month. First, you should understand which federal and state rules you are subject to. These will generally be the IRS regulations and the state you are operating in. The IRS has extensive resources available online to guide you.
Another bookkeeping best practice is to consider automation. Recent technological advancements have made it simple to complete bookkeeping on a regular basis. Instead of spending hours typing transactions into a spreadsheet, you can connect your business bank account with your software and have all transactions uploaded, eliminating the need for manual entry. Real estate accounting software that prioritizes efficiency and productivity is vital to free up time in your busy schedule. Instead of spending hours entering transactions, you can be on the lookout for your next investment.
Many real estate investors report their rental income or loss on their individual returns. This creates a potential liability when personal and business expenses are commingled. If one of your tenants sues you and you don’t have the proper separation between expenses, the court system may come after your personal assets to satisfy any judgments.
To promote separation of expenses, open a separate business bank account for your rental investments and only run business transactions through that account. Not only will tax time be easier when you have all transactions in one place, but you can also promote the proper separation.
What are Ways to Increase Productivity and Accuracy?
Who really wants to spend hours logging expenses into a spreadsheet? How about taking days or weeks before you can view your financial statements? By finding the proper tools to increase productivity and efficiency, you can take your real estate business to the next level. A real estate accounting software program that prioritizes reporting for real estate investors is critical to derive the most value from your transactions.
From maximizing profits through money management to tracking expenses related to each rental, the capabilities of software automation are endless. Additionally, software programs are more accurate compared to spreadsheets and handwritten expense logs. When you don’t have the proper tools to ensure accuracy, you run the risk of filing incorrect tax returns, which the IRS doesn’t take lightly.
Furthermore, preparing for tax time is a burden for many real estate investors. When you are able to prepare regular monthly reports and enter all transactions in real time, you don’t have to backtrack your transactions for the full year. Instead, you just need to pull a report. What used to take business owners days or weeks can now be completed in a matter of minutes, freeing up time and improving accuracy.
Summary
The real estate market is booming, meaning now might be the right time to enter the market or expand your current business. Whatever stage you are at in your real estate investing journey, you want to have the right resources working alongside you.
The team at Ennis Investments recommends working with Stessa, an accounting software that is tailored to real estate investors. Stessa provides all the features and reporting capabilities your business needs to evaluate return on investment and make informed decisions surrounding growth. For more information, reach out today to talk to one of our team members.
Sources
Fragnito, Aaron. “Find Your Return on Investment (ROI) in Real Estate.” Peoples Capital Group, 20 May 2022, https://www.peoplescapitalgroup.com/average-roi-real-estate/. Accessed 14 Oct 2022.
IRS. “Topic No. 414 Rental Income and Expenses.” IRS, 4 Oct 2022, https://www.irs.gov/taxtopics/tc414. Accessed 14 Oct 2022.