Accounting Methods in Real Estate: GAAP vs. Income Tax Basis

Accounting Methods in Real Estate: GAAP vs. Income Tax Basis

By Lisa Timbrook, Senior Manager

In financial reporting for real estate, Generally Accepted Accounting Principles (GAAP) and the income tax basis of accounting often yield very different financial reporting results. If the real estate entity is a publicly traded company, GAAP reporting is required. However, if there is no mandate on an entity’s choice of accounting method, real estate owners should be aware that the income tax basis of accounting might better serve their needs. This article will highlight some of the most common differences between the two accounting methods.

Rental Revenue Recognition

Under GAAP, rental income is generally recognized evenly over the life of the lease (the straight-line method). Commercial leases commonly include rent abatements or holidays in addition to escalation clauses. Any rent bumps and holidays are factored into determining the constant rent throughout the entire life of the lease. For example, if a tenant has a six-month rent holiday at the beginning of its 10-year, $100,000 monthly lease the income reported by the landlord in year one under GAAP would be determined as follows:

  • $100,000 per month multiplied by 114 months (120-months minus six months) equals $11,400,000
  • Divided by 120-months equals $95,000 monthly rent amount
  • $95,000 monthly rent multiplied by 12 months equals $1,140,000 year one GAAP rental income
  • Difference between the recognized GAAP income of $1,140,000 and year one rental income actually billed and received of $600,000 (6 months*100,000) would be recorded as a deferred rent asset on the balance sheet

Under the income tax basis of accounting, the treatment is generally simple: rental income reported on the financial statements would be $600,000 in year one of the lease (6 months*100,000). Assuming all billed rent was also paid, the amount reported is in sync with the $600,000 cash flow received from the tenant in year one and the reportable rental income on the company’s income tax returns.

Sometimes tenants will prepay the succeeding year’s rent in advance of its due date. If the real estate company uses the income tax basis of accounting, the tenant’s prepayment would be reported as income in the year it’s received. For GAAP reporting, the prepayment would be recorded as deferred rent liability on the balance sheet until it is earned in a subsequent year.

Depreciation

For those entities that report using GAAP, property such as building and equipment would be depreciated using a systematic method over the assets’ estimated useful lives. If sometime down the road the estimated useful life of the asset changes, GAAP would require that the carrying value of the asset be depreciated using the new estimated life. Changes in depreciation lives and methods create disclosure and other considerations in GAAP basis financial statements.

Depreciation of real estate assets under the income tax basis of accounting is computed using applicable rates and lives as allowed for federal income tax purposes under the Internal Revenue Code (IRC). The tax basis method ignores the fact that the real property may have reached the end of its useful life. What’s more, the IRC provides accelerated depreciation deductions for certain qualifying assets such as “bonus depreciation” and “IRC section 179 deductions”. No accelerated depreciation deductions apply for GAAP reporting purposes.

Organizational Costs

The cost of forming a business often includes legal fees for drafting bylaws, a state filing fee, accounting costs incident to organization, etc. These organizational type costs are treated very differently for GAAP and income tax reporting purposes. For GAAP reporting, organizational costs must be expensed in the year the business begins. For tax basis reporting, a business can elect to deduct up to $5,000 of organizational costs in the first year, and the remaining balance must be amortized over a 180-month period.

The key question is: Are tax basis financial statements right for the company? There are potential pros and cons on both sides. The income tax basis of accounting allows a company to capture tax deductions that are not available under GAAP reporting. However, the tax basis of accounting may also cause larger income variations from year to year depending on cash flow results. Real estate owners should consult with their accountants and weigh their options.