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Last week I wrote an article on accounting best practices for flippers. I decided I shouldn’t leave the buyers and holders out, as I am one myself, so I wrote this week’s article on accounting practices for buy and hold investors.
Both flippers and buy and hold investors need to develop systems for their businesses in order to streamline operations and increase efficiencies. Implementing systems allows you, the business owner, to maximize the value of your time by focusing on what is most important to growing your business. One such system is that of accounting.
Accounting will look quite different for the buy and hold investor versus the flipper. For one, the buy and old investors will typically have fewer transactions (assuming the property is already rehabbed) than the flipper. Additionally, there will be a difference in the expense categories that should be used and a difference in the profit and loss (P&L) statements that will be generated. All of this will be discussed below.
As I mentioned in last week’s article, developing a good accounting system isn’t as difficult as it sounds. There are software programs and apps that will help you stay organized. Just remember that a “system” is supposed to help you streamline your business. It should be so easy to run that you can delegate it to a competent employee with minimal instruction, and they can run it without error.
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Developing an Accounting System
An accounting system is one that is comprised of manual or computerized records of financial transactions for the purpose of recording, categorizing, analyzing and reporting timely financial management information. For a buy and hold investor, we will want to build a system that allows you to scrutinize your portfolio year round and to easily hand off your books to your tax professional at year end. Your books should be as clean as possible to minimize time spent on your books by your professional at year end.
A great accounting system will act a business management tool providing the business owner with timely and relevant information to make business decisions. Setting up a great accounting system requires a three-pronged approach:
- Software utilization
- Streamlined bookkeeping
- Accessible and organized records
The first item on the list is software utilization.
Notice I said you need to utilize software for a “great” accounting system. You can use the shoebox method, where you essentially keep all receipts in your shoebox or a file folder, but this method will come with massive costs at year end in the form of your time or your tax professional’s billable time.
You need to find software that is easy to use and will meet your accounting requirements. I use QuickBooks with my clients who require bookkeeping services because the online version allows us to easily collaborate with one another. QuickBooks is built for accounting, so it’s naturally near-perfect for use in an accounting system. Buildium (to learn more about Buildium, click here) is also popular among landlords, as it is geared toward property management. While I have not used Buildium, I have been told that it does not have the same accounting power of QuickBooks, though you may not need powerful accounting. I don’t think you will go wrong with either of these programs (or additional programs out there). You just need something that you will continuously use to keep your books up-to-date.
MS Excel works perfectly fine for smaller landlords, generally with four properties or less. I have found that my clients who have more than four properties generally need to utilize more powerful software to keep them organized and further streamline the accounting system. I built out a bookkeeping tool for my clients with a small portfolio to use; so check with your own professional to see if they have done something similar.
In terms of apps, make sure you find a couple that allow you to easily record expenses on the go. I mentioned Expensify (no affiliation) in last week’s article and will also recommend this app to the buy and hold investors. It allows you to scan in receipts, categorize and date them, and also produce reports for expense categories. You should also be using mileage apps (or a notebook) to track mileage while you are on the job. For 2015, every mile you drive will result in a $0.575 deduction using the standard method.
The second item on the list is streamlined bookkeeping.
This goes hand-in-hand with picking software to meet your needs, as discussed above. More importantly, bookkeeping needs to be done on a regular and continuous basis. You can have the most powerful software in the world, but if you don’t use it, then it’s pointless.
My recommendation is to pick a day during the week and dedicate at least one hour to entering income and expense information and reconciling your accounts. Turn your cell phone and TV off, lock yourself away, and pump the bookkeeping out. The longer you wait, the more tedious bookkeeping becomes.
While I will discuss expense categories below, make sure that you write notes or a description of expenses that are either non-recurring or you are confused about. At year end when you hand your books off to a professional, they will help you re-categorize questionable expenses, and your descriptions of such expenses will help immensely.
If you find that you hate bookkeeping or have complicated partnership structures, you may want to consider hiring a professional. I generally recommend to tough it out for the first four properties, and once you hit the fifth, it may be time to hire a bookkeeper. The reason for this is you don’t want accounting, a cost center, to be a huge line item (percentage wise) on your P&L. After five houses, you will likely be grossing $4,000 – 5,000 a month, so bookkeeping costs will be small relative to gross income.
The third item on the list is accessible and organized records.
It is not the job of a tax professional to audit the information you furnish to him/her. They simply take the information and apply it to your returns. However, you will want easily accessible and organized records in the event that you are ever audited. The best way to do this is to go the paperless route via the software I described above. Any time an expense is questioned, you will be able to quickly pull up the receipt or invoice and provide a defense. Organization is a great audit defense.
Expense Categories and a P&L Example
Many times, new clients as me how they should be keeping their books and if there are any expense categories I’d like them to use. I generally direct my buy and hold clients to map their expenses to that of Schedule E, as that’s how I will eventually be categorizing the expenses. Those categories are:
- Auto and travel
- Cleaning and maintenance
- Legal and other professional fees
- Management fees
- Mortgage interest
- Other interest
- Depreciation expense or depletion
- Other (list)
If you are ever confused about what category you should assign to an expense, make a best guess and be sure to adequately describe the expense in your notes. You can then flag it and bring it up to your tax professional for their input.
I do want to make a note about repair expenses – due to the final IRS tangible property regulations, which were enacted in 2014, I ask that all of my clients adequately describe ALL expenses they categorize as repairs or capital improvements. While beyond the scope of this discussion, the final regulations detail how you classify repair expenses versus capital improvements, so this is the one area I don’t want my clients categorizing themselves.
At the end of the year, you will want to see a P&L. If you are using MS Excel, I’d recommend you build out a template that looks similar to Schedule E and allows for your income and expenses to automatically flow into the P&L statement. I have provided a screenshot below of what the P&L template I’ve built as part of my bookkeeping tool for my clients looks like:
Do Landlords Have to File a 1099?
Form 1099 is used when you pay unincorporated contractors an excess of $600 annually. It is purely an informational return for the IRS and is used to make sure contractors are reporting their earned income. Unfortunately, if the IRS determines you failed to file, you will be slapped with hefty fines.
There has been significant confusion surrounding whether or not landlords need to file form 1099s. Many landlords in the business of owning a rental property consider it an activity carried on regularly and continuously for profit. However, the IRS considers most rental activities to be passive activities, rather than active businesses.
Congress sought to clear up the confusion by passing a law in 2010 that explicitly defined receiving rental income as conducting the trade or business of renting out property and therefore subject to 1099 reporting requirements. They then repealed that law before it ever took effect.
So the AICPA tried to clear up the confusion and wrote an open letter to the IRS in 2013 to express its position and request further guidance. The AICPA took the position that landlords only need to file form 1099 when their rental activities rise to the level of a trade or business. While still awaiting clear guidance, it is the position of the AICPA that most small landlords remain exempt from the requirement to file 1099 forms for their service providers.
With my clients who own more than a couple of rentals or plan on growing their portfolio, I go ahead and tell them to issue 1099s to their contractors and service providers. I want my clients to be on the safe side of a failure to file penalty, and they may as well go ahead and implement best practices if they are looking to expand their business to a larger scale.
Implementing accounting best practices will streamline your bookkeeping efforts and provide you with a business management system that provides you with timely and relevant information. This information will be imperative when making business decisions and organized books will save you time and money at year end when preparing your taxes. Don’t wait until the last minute to do your bookkeeping!
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
Buy and hold investors: What best practices do you use when it comes to your business? How do you keep your bookkeeping organized?
Let’s talk in the comments section below.