Frustrated with complicated rules of business bookkeeping? Join the club! Indeed, bookkeeping often makes little or no sense.
Let’s consider this simple sequence of events:
- you deposit $3,000 of your personal money into your business account
- you write a $500 business check to your marketing assistant for her services
- you use your business debit card to pay $50 for a business networking lunch
- you buy a new $1,000 laptop using zero-down, 90-day same-as-cash promotion from BestBuy
What does your bank account show the next day? Since nothing has been paid for the laptop yet, you will see $3,000 – $500 – $50 = $2,450. Of course, I assumed that your consultant cashed your check the same day, which is what I would have done. How much money do you have left? $2,450. Easy enough.
Unfortunately, correct tax bookkeeping will show anything but $2,450. To make it truly mind-boggling, there is more than one possible answer, all of them correct from bookkeeping angle. The most common result will be a negative -$1,525. Alternatively, it could be negative -$1,125, negative -$725, and a number of other possible answers. Weird, I agree.
How could it happen? Well, for starters, money transferred between accounts is not income. If it was money from selling something to a customer or payment for services or rent – then it would count. As is, $3,000 is ignored for tax bookkeeping purposes.
The $500 professional services payment is the only no-brainer item on the list. However, $50 business lunch is different. The reason is the annoying IRS rule that allows you only 50% deduction for business meals and entertainment. In other words, only $25 of the $50 will be allowed by the IRS.
Finally, about that $1,000 laptop computer. It does not matter that no payment has been made yet. For bookkeeping purposes, the entire $1,000 has been spent the moment you signed the paperwork. What you have now is simply a loan from BestBuy. It’s between you and BestBuy now, and the IRS can’t care less. For tax purposes, the $1,000 is spent. However, a computer is considered an asset rather than an expense. As such, its cost cannot be treated as an immediate deduction, the way we deducted $500 payment for marketing help. It has to be depreciated. Depending on various conditions, you will have options for depreciation:
- standard 5-yr depreciation, which gives you $200 in the first year
- last-quarter depreciation reduced to $50, if the purchase happened late in the year
- “50% bonus” depreciation available during 2013, resulting in $600 total deduction
- “Section 179” depreciation allowing full $1,000 deduction under certain conditions
- and several additional options, in case the above choices are not confusing enough
There are two ways to do bookkeeping: one is for tracking actual cash flow of your business; the other is to comply with the IRS taxation rules. These two approaches are incompatible. You must choose one, and it is usually the IRS version.
One question is obvious: how on earth can a business owner know all these rules that defy common sense? The answer is: only by getting some training in taxation and bookkeeping or by relying on a professional bookkeeper/accountant to do it for him.
Unfortunately, even professional bookkeepers are likely to be stumbled when it comes to the peculiar special rules of the real estate business. Yes, it is much more complicated than a conventional business, such as a dental office or a restaurant. Just a few examples:
- Income and expenses related to rental properties must be separated from all other real estate business activities, such as flipping, rehabbing, or wholesaling.
- Expenses directly related to flip properties are accumulated separately from all other expenses and applied against sales price of the property when it is sold.
- Financing of properties does not matter for tax purposes. You must record the full purchase price of the property, as opposed to your down payment or an amount of cash brought to closing.
- Closing costs are mostly added to the purchase price of the property. Only a few of them are deductible, and some of them should be recorded separately and deducted via amortization.
- Section 179 instant depreciation is not available if your business is leasing rental properties.
- Escrow accounts set up for initial repairs or for taxes and insurance are ignored in tax accounting. The only time we record something is when a payment is made out of the escrow.
- Repairs is a tricky term. It can be deductible repairs (like painting or clean-up), improvements (like a new roof or a bathroom upgrade) or removable assets (like carpet or light fixtures). Each of these groups must be recorded separately.
Because of these (and many other) special rules of real estate bookkeeping, every real estate investor (and bookkeepers working with investors) must learn how do it right. And this is why we recorded our 2-day Real Estate Accounting boot camp.
I was really impressed with your ability to take a complicated and boring subject and not only make it easy to understand but actually fun, no I really mean it. Probably the most valuable thing I picked up today is the relationship between bookkeeping as a business and bookkeeping for taxes. I liked the way you kept us engaged. Thanks for the sacrifice you made in making such a good presentation.
Ray Sasser, REI investor, mentor, and former President of the RICH club.
I really liked how you broke it down. It was really easy to follow and understand. I have a great understanding now of what needs to be done. Your class could not have come at a better time. GREAT CLASS! I really got a lot out of it!
Will Denker, Master wholesaler, 10 years of REI experience.