Is the Income Tax Basis of Accounting a Better Option for Your Real Estate Entity?

The financial reporting of real estate entities typically follows either U.S. generally accepted accounting principles (GAAP) or the income tax basis of accounting (Tax Basis). Lenders or investor partners may require financial statements in accordance with GAAP in connection with the loan covenants or the terms of a partnership or investor agreement. However, Tax Basis financial statements may provide an alternative approach for financial reporting that may align more closely with the economics of the business. Following are some of the key differences between GAAP and Tax Basis financial reporting for real estate entities:

  1. Depreciation – Under GAAP financial reporting, real property is depreciated using a straight-line or other systematic method over the estimated useful lives of the assets. Depreciation under Tax Basis is calculated in accordance with the prescribed methods and lives in the Internal Revenue Code (IRC). There are many benefits with tax depreciation under the IRC, including accelerated deductions for certain qualifying assets through bonus depreciation, immediate write-off under IRC Section 179, and expensing of certain property improvements that may qualify as a repair under the Tangible Property Regulations.
    Additionally, a cost segregation study may result in significant tax advantages. Through a cost segregation study, certain costs of a building are classified through an engineering-based study to personal property, resulting in shorter taxable lives and accelerated depreciation.
  2. Rental Income – GAAP requires the recognition of rental income on a straight-line basis over the lease term. Rental income is often recognized earlier under Tax Basis reporting, because amounts are recognized when payments become due or payments are received. Additionally, prepaid rents would be included in rental income in accordance with the IRC.
  3. Impairment of Rental Property – GAAP requires entities to review long-lived assets, including real estate, for potential impairment when facts and circumstances indicate that the carrying amount of the asset may not be recoverable. An impairment charge would be recognized under GAAP when the carrying value exceeds the fair value of the asset. Impairment charges are not permitted for Tax Basis.

In addition, under Tax Basis reporting, start-up and organizational costs are capitalized as opposed to expensed, no allowances are made for delinquent accounts receivable until directly written off, and there is a different approach to account for acquisitions. Finally, derivative financial instruments such as interest rate swaps are not recorded under Tax Basis reporting, but they are recorded at fair value under GAAP.

Financial reporting for real estate entities using Tax Basis tends to be less complex than GAAP and may provide a clearer picture that aligns closely with the cash flow and economics of the business.  Before considering a change in financial reporting to Tax Basis, you should consult with your lenders, investors, and accounting advisors to see if it is permissible per the terms of your agreements, and if it is a better option for the users of your financial statements.

John J. Helmuth, Jr. can be reached at Email or 215.441.4600.

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