by Diane Kennedy
As a CPA, I'm often contacted by clients looking for damage control on tax issues. Sometimes I'm able to help them, but other times I can't. What frustrates me the most is that in many of these cases I could have helped, if only the client had come to me before getting into the deal. Jumping into a real estate investment without understanding the tax or accounting consequences of the deal can wind up costing you thousands, and, as far as I'm concerned, is the biggest mistake real estate investors make.
Many beginning real estate investors lose the paper trail in the excitement of the investment. That trail winds up in a shoebox on a CPA's desk at the end of the year, when that CPA is stressed and in the busiest time of the year. Not exactly optimal circumstances for getting the best possible information and advice.
Here are just two trouble areas that wind up costing novice real estate investors money: not recording the "Buy" and the "Sell" correctly.
When you buy a property, you'll receive a closing statement, also known as a HUD-1. Make sure you get the property accurately recorded on your records as soon as you buy the property. Some of the line items will be "capitalized," meaning that the item is considered an asset and then the cost is either amortized or depreciated over time. Other line items will be current expenses. That means you get the write-off for the expense right away. Is this important to know? YOU BET! You want to claim as many expenses as possible. A common mistake is to just count all of the expenses as capitalizable at the beginning.
You'll also need to also record the entry to break out the value of the land versus the value of the real property versus the value of the personal property. Why? Because your investment is actually comprised of different pieces that are all depreciated over different lives. Land is never depreciated -- no deduction there. Real property is depreciated over 27.5 or 39 years (it depends). Personal property is depreciated over 5-18 years.
While you don't get more depreciation using this breakout, you do get the benefit of front-loading your depreciation. Depending on your long-term plan for that property, having more depreciation in the early years (say 2-5 years) can be a good thing. When the deduction begins to drop, it could be time to sell the property. Then again, if you don't qualify as a Real Estate Professional and can't deduct all of your real-estate losses each year, you may want to take that deduction over a longer period. It really depends on your own individual circumstances.
That's just basic accounting for the buy. There are also all of the creative real estate techniques such as sandwich leases, lease options, foreclosure and pre-foreclosure buying to consider. Getting your accounting wrong can cost thousands in extra taxes. Conversely, going through your plans with your CPA ahead of time could save you thousands.
When it comes to recording the sell on the other hand, it would seem straightforward, right? You collect the cash and put it in the bank. But it's not so simple. There's some accounting associated with that cash.
For example, you'll need to know the basis for that property in order to correctly calculate the gain. Novice investors often confuse the cash they receive as their gain, but there are a lot of things that can make the two very different -- previous Section 1031 exchanges, refinances, mortgage payments, and depreciation. In fact, the cash you receive often doesn't even come close to what the gain actually is.
And again, that's the basic accounting part. You'll still have the creative real estate to consider such as lease option, wraps, wholesaling and rent to own programs to consider. This is when the accounting gets really fun and if you do it wrong, you might find that you have to pay an extra $10,000 or more on the gain.
If you've read this article and your head is spinning, then I urge you to contact your CPA or tax planner and schedule a sit-down talk to learn more about these two accounting mistakes -- not to mention the myriad of other mistakes that could be costing you, big time.
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