What you Need to Know About Accounting as a Landlord
It may not be the most glamorous part of any job, but accounting is critical to every business.
Things like understanding the terminology, knowing how to track income and expenses, planning for the future, and preparing for taxes are foundational to the success of your rental business.
The complexity of accounting can make it daunting, so it’s essential to do your homework.
In this article, we will cover what you need to know about rental property accounting at a high level.
With this base of information, you can make informed decisions and enhance the financial health of your operation.
Best Practices
The following best practices for rental property accounting can help you manage your money wisely.
Separate Your Personal and Business Accounts
Open separate checking and savings accounts, credit cards, and debit cards for your business. Keeping your personal finances separate from your business finances will save you a lot of headaches. Not only does the separation help when tax time rolls around, but it may also be required by local landlord-tenant laws in your area.
Record Income and Deductible Expenses
If you keep track of all your rental property expenses as they occur, you can avoid desperate maneuvering at the last second to account for everything throughout the year. Preparation will help you and your accountant.
With many property management software platforms like Innago, bookkeeping is automated, which saves you a lot of time and potential headaches. Rent payments you collect through our system and maintenance expenses you record will automatically sync to your dashboard.
One of the most vital parts of tracking is understanding deductible rental expenses like legal fees and repair costs. These can substantially reduce your tax bill at the end of the year.
Choose Between Accrual or Cash Method of Accounting
Cash and accrual accounting are the two main methods. You will need to choose one of them for your business.
If you want to record income and expenses as they’re incurred (regardless of when the cash leaves or enters your account), use the accrual method.
What’s an example of this? Let’s say a tenant pays rent in February. Using the accrual method, you record that transaction in February.
However, if the same tenant pays for two months ahead of time, you’d still only record this month’s rent as a transaction even if the funds are in your account.
The following month you’d mark down that rent payment as it occurs for that month.
Conversely, use the cash method if you prefer to track income and expenses as they get to your account.
What’s an example of this method? Let’s say a tenant pays you $1,600 for rent in January. You then record that transaction right away. Yes, it’s really that simple with the cash method.
It’s important to note that you cannot use the cash method if your business maintains inventory, is a corporation, or has gross receipts exceeding $26 million per year.
Most big businesses use accrual accounting to better understand income and expenses during different time periods. That said, smaller companies may benefit from using the cash method to keep track of precisely how much cash they have at any given time.
Ultimately, the choice comes down to personal preference and what works best for your business. The key is consistency. Pick one accounting method and stick with it.
Embrace Digital
Whether it’s applications that can digitize receipts and invoices, accounting software like QuickBooks to integrate your financial record keeping and financial analysis in a central location, or property management software to automate record-keeping, digital tools will improve your business.
The less you rely on paper, the better. Paper records aren’t necessarily a bad idea, but storing records online (i.e., in the Cloud) is good because of the enhanced reliability, security, and accessibility.
Familiarize Yourself with Relevant Tax Forms
Another critical principle of accounting for landlords is familiarity with relevant tax forms. The Internal Revenue Service (IRS) typically requires landlords to complete a Schedule E (Form 1040). This form is for reporting rental income and expenses for each of your properties. Additionally, you’ll need to report rental income that exceeds $600, in light of the IRS’ newer 1099 requirement.
In addition to the forms above, every employee or contractor that performs work for you will need W-9 and 1099 forms.
Read about these forms and understand what is needed. Taxes aren’t the sexiest topic, but the more you know, the better off you’ll be. And the penalties for errors on these forms aren’t fun, so it’s wise to do things right the first time.
Consider Hiring a CPA
No one is an expert in every field. Thus, as a landlord, it’s usually wise to hire a CPA for your rental business.
An accountant will help you stay compliant. There are a lot of tax requirements and regulations that rental property owners must adhere to, and failure to comply results in penalties and fines. A CPA will help you navigate tricky waters with ease.
Furthermore, professional accountants can help you create budgets and analyze trends. This expertise sets your business up for long-term success because you’ll make more informed decisions with their guidance and experience as a foundation.
A CPA can also help you prepare for retirement and create a sustainable business plan. A rental business without a plan is a car without a steering wheel.
Lastly, a professional accountant is a reliable source you can go to with questions and issues. Being a landlord can be stressful, so having an expert in your corner is valuable.
Terminology You Need to Know
Just like best practices, there are specific rental property accounting terms you need to know. A basic understanding of these terms will help you immensely.
Accounting Period
If you pull reports from QuickBooks or other accounting software to analyze revenue and expenses, you’ll see that each report uses an accounting period.
An accounting period is a defined range of time in a financial statement. It can cover several days, months, or even years.
Operating Expenses
Operating expenses impact the daily operations of your business and are necessary to manage a rental property. An integral part of rental property accounting is to know what are considered operating expenses.
It’s also important to ensure something is an operating expense before categorizing it as such. Check out our article on operating expenses for more details.
Accounts Payable
Accounts payable refer to your short-term obligations owed to vendors or suppliers, which haven’t been paid yet.
Accounts Receivable
This term refers to what you’re owed for your services. Any outstanding invoices, rent still due, or unpaid fees go here.
General Ledger
The general ledger (G/L) is the complete record of all your business transactions. If you use accounting software, it generates this automatically as you enter transactions.
Fiscal Year
This term refers to the traditional 12-month period in which a property’s financial records are tracked. This isn’t necessarily the same as a calendar year because it won’t always start on January 1st.
Bank Reconciliation
It’s crucial to ensure your general ledger matches your official bank statement. It’s wise to do this monthly if you can. The process of comparing these statements is called bank reconciliation.
Asset
An asset is something a business owns that has value. Land, accounts receivable, and property are all examples.
Equity
The value of an asset once you subtract liabilities.
Revenue
This term refers to the income your business generates over a certain period of time.
Overhead
Overhead refers to the total cost to run your business, excluding the actual service you provide. Thus, office rent, utilities, and payroll are all examples.
Credit
Credit refers to every transaction appearing on the right side of an asset account. Credit indicates money leaving an account (I.e., decreasing an asset).
Debit
Debit, on the other hand, refers to every transaction appearing on the left side of an asset account. Debit indicates money entering an account (I.e., increasing an asset).
Depreciation
Depreciation is the mechanism for recovering costs on an income-producing property over the property’s expected life.
You can write this off on your annual taxes for certain items, so depreciation related to your assets is something you want to track.
Gross Profit
You can find gross profit by subtracting the costs of business expenses from your revenue.
Net Profit
Net profit equals your revenue minus every cost related to running your business. This figure includes your overhead costs.
Liability
This term refers to something you owe or have borrowed. Examples are your mortgage, a loan, and accounts payable.
Financial Statement
A financial statement is a report that provides information on the health of your business. Examples are balance sheets, profit and loss records, and income statements.
Key Financial Metrics
Now that we’ve covered foundational practices and terms, it’s time to look at key financial metrics you should track. Part of good rental property accounting is tracking metrics that tell a story. These will help you make better business decisions. Below are some metrics that you need to track:
Net Operating Income (NOI)
NOI or net operating income is a calculation used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property minus all reasonably necessary operating expenses. Examples of operating expenses are property manager fees, legal fees, general maintenance, property taxes, and utilities you pay for.
Your mortgage payments aren’t included in the NOI calculation because those aren’t considered operating expenses.
NOI helps lenders judge whether investors will have enough cash flow to make loan payments. Additionally, lenders sometimes use NOI if they’re trying to gauge the likelihood of an investor repaying a loan.
There are downsides to using NOI, though. Projected rents could prove inaccurate, which would have a negative impact. Furthermore, income might be inconsistent if the building isn’t managed properly.
Internal Rate of Return (IRR)
IRR estimates the interest you’ll earn on each dollar invested in a rental property over its holding period. This calculation goes beyond net operating income and purchase price to predict long-term yield.
When calculating IRR, put the property’s net present value (NPV) at zero and use projected cash flows for each year you plan to have the building. NPV is the value of money now instead of in the future after the money accrues compound interest. It’s a complex formula, so it’s wise for most landlords to use the IRR function in Excel to determine the ratio.
While it’s a helpful measure, IRR does have limitations. It assumes a stable rental environment and an absence of unpredictable repairs. The properties you compare should be similar in size, use, and holding period.
Cash Flow
Cash flow shows how your business is performing. It reveals your net cash left at the end of the month after you’ve collected rent payments and paid expenses. As an example, if you rent out a building for $2,500 a month, and all costs are $1,500, your net cash flow is $1,000.
Don’t let the simplicity of this one fool you, though; cash flow is a critical measure. If it’s negative, you won’t be able to pay your bills or turn a profit. Negative cash flow could indicate that you need to review your expenses. Or it may signal that you have a problem tenant whose late or partial payments are hurting your bottom line.
Return on Investment (ROI)
This metric shows how much income your property produces versus how much you invest to maintain it. The basic formula is annual returns divided by the cost of the investment.
ROI is significant because it highlights your business’s financial health. It helps investors see how well a property is doing and reveals areas needing improvement.
Occupancy Rate
Occupancy rate is a valuable metric for landlords. It lets you know how appealing your property is in the current market. You calculate it by dividing the number of occupied units by the total number of units on your property, and then you multiply the result by 100 to get a percentage.
A high occupancy rate means that your rental property is in demand. It also means you’re making money from your property.
On the other hand, a low occupancy rate may signal that your rental property isn’t competitive in the market or that you need to make improvements to appeal to tenants. A poor measure can be an excellent wake-up call to enhance your property or consider new strategies.
Tracking your occupancy rate over time also helps you spot trends and patterns in tenant behavior. For instance, if you identify a seasonal trend where tenants tend to move out during the winter months, you may want to adjust your marketing and pricing strategies to account for this trend.
Rental Income
It might be the most obvious metric, but it also might be the most important. Rental income is the total amount of money that you receive from your tenants each month or year.
By tracking rental income, you ensure your prices are fair and generate enough income to cover your expenses. This metric also helps you calculate your gross rental yield, which is the rental income earned as a percentage of the property value. You can use this to compare the performance of your property to competitors’ properties in the same market.
Several factors impact your rental income, including the condition and location of your rental property, the demand for rental properties in your area, and the rental rates of your competitors. Tracking this metric allows you to understand what changes in these factors might benefit your business.
Conclusion
The principles and practices outlined in this article are vital to building a great rental business.
The importance for landlords of accounting and financial planning cannot be overstated. A great approach will save you time and money while allowing your business to thrive.
