Real estate entities in all stages of their lifecycles are often required to obtain audited or reviewed financial statements from an independent public accountant. The requirement can be part of obtaining a construction loan in the very early stages of the entity or part of a recapitalization that entails admitting a new member, such as an institutional investor, into the venture for a stabilized property.
Audited financial statements are a typical financial reporting covenant for commercial properties. The standard language that both lenders and investors often use in loans or partnership agreements requires the entity to provide annual financial statements, audited or reviewed by an independent CPA, in accordance with United States Generally Accepted Accounting Principles (GAAP). This is primarily due to the fact that GAAP is the most common and known accounting method, but certainly not the only one and, at times, not the best choice for certain real estate entities.
Agreeing to such language will require the real estate entity to use GAAP as a basis of accounting for financial statement purposes and the tax basis of accounting for federal and state tax filings. In order to produce financial statements in accordance with GAAP, the entity must maintain two separate sets of records. While entities such as publicly-traded REITs and other regulated entities are required to use GAAP, small- to medium-sized private entities might have a more suitable option: income tax basis of accounting.
The income tax basis of accounting is defined as the basis of accounting that the reporting entity uses to file its income tax return for the period covered by the financial statements. The first and most obvious benefit of electing a tax basis presentation is the elimination of the need to maintain two sets of records. Since entities are already required to prepare tax reporting to comply with federal and state regulations, companies can capitalize on the majority of the preparatory work used in completing the tax returns. There are several differences between the two financial reporting frameworks, and below are some of the most common ones that arise in real estate financial statements:
GAAP requires management to evaluate long-lived assets for impairment based on certain market indicators. If an impairment is noted it has to be charged to operations. This evaluation is not required when using the income tax basis of accounting. Deductions only occur through depreciation charges, and a loss can be recognized only if the asset is sold. This difference is very important in volatile economic times such as the one resulting from the COVID-19 pandemic.
Under GAAP, rental revenue from long-term leases (greater than one year) is recognized on a straight-line basis over the lease term. This creates the need for additional calculations that can get complex in leases that contain step-ups in rent and free rent periods or that are modified during their terms. When using the income tax basis of accounting, rental revenue is recognized as billed to the tenants in accordance with the lease.
Purchase Price Allocation
GAAP requires real estate entities to allocate the purchase price of an acquired income-producing property to tangible components (i.e., land, building, improvements, etc.) and intangible components (i.e., above or below market leases, in-place leases, etc.). This allocation can be very complex and will often cause the real estate entity to have to engage a specialist to assist in determining the fair value of each component. Income tax basis requires an allocation of the purchase price only to tangible components.
There are several other differences between the two accounting methods, such as recognition of depreciation and organizational costs, consolidation requirements and treatment of related party transactions.
Reporting entities have many factors to consider when determining the acceptability of an accounting method. Using the income tax basis of accounting could result in financial statements that are more closely aligned with the economics of the deal and that can be easier to read and understand.
Management should consider the financial information needs of the intended users, which in most cases are lenders and/or investors. Real estate owners should be aware that lenders and investors are usually open to negotiation when it comes to determining the financial reporting basis to be utilized and they are encouraged to discuss the different reporting options with their accountants prior to entering into new lending and/or partnership agreements.
Raffaele P. Di Censo
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