We had the opportunity to sit down with Trevor McCandless from Fusion CPA, where we talked about accounting, tax planning, and closing out the year. The session was targeted at real estate owners.
There are three phases to keep everything connected:
- Stabilization phase and common actions for closing out the books at the end of the year
- Analysis phase where we address common topics around Qualified Tax Deductions and Depreciation, and estimating tax liabilities
- Growth phase we dig deeper into the numbers and look for ways to generate more excess cash flow.
Disclaimer: We are covering Tax Planning and Accounting Principles at a high level. While I am a CPA, you need to engage your own CPA or Fusion CPA to give you customized advice for your specific situation.
Phase 1 – Stabilization Activities to Close Out the Year
What records do you need to update at the end of the year?
We list out 3 record types to focus on for reconciliations in the annual closeout process. They are:
- Bank and credit card accounts
- Escrow accounts
Reconciling Bank And Credit Card Accounts
Reconciling and including all transactions from each property or entity’s bank and credit card accounts is absolutely mandatory. If you aren’t the one managing your accounting or QuickBooks files, you may have no idea how to check this. That’s common for some property owners. However, all owners should have access to their QuickBooks files even if your Internal team is not doing the day to day data entry.
The action item here is for you as the owner or your finance lead to login into your account and run a Balance Sheet report for each legal entity. Here you will eyeball the balances for each of your bank accounts and credit card accounts.
If, for example, you work with Bank of America, look at your 12/31 statement (or whatever is the last statement for the year). Compare the balance on your Bank of America statement to your Balance Sheet balance. The two balances should match.
If there are differences, have your account address the differences or dig into the discrepancy yourself. Fortunately, short term accounting problems can be fixed; we need to roll up our sleeves and get to work. The errors typically come from:
- missing transactions
- double-counted transactions
- misclassified transactions
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Make sure all your escrow accounts are up to date and reconciled. The process is very similar to the one you use for your checking and credit card reconciliation process.
Compare the escrow account balances to your lease contracts or your mortgage closing statements and make any necessary adjustments.
Loan Payment Reconciliations
This is a common area where owners struggle. The action item for your team is to make sure that you have your amortization schedules in hand and compare them to the financial statements.
First, make sure your debt balances as reported on your balance sheet match the debt balance as reported on your year-end mortgage statements and amortization tables. You should receive your year-end mortgage statement very close to the end of the year. This same information is also available online for many lenders as well.
Second, we want to confirm that the interest deductions on your Income Statement match the interest payments on the year-end mortgage statements as well as the amortization schedule.
The most common issues found are:
- Owners try to deduct the entire mortgage payment.
- We see the entire loan payment being treated as a distribution, which would make it fully non-deductible.
- When there was some mid-year change resulting in a change to the amortization schedule’s accuracy. This can happen if a payment was missed or terms were re-negotiated on interest rates. Or sometimes, there could be a situation of debt forgiveness.
Experience and access to good accounting resources that oversee your books will make this phase go smoothly.
Phase 2 – Analysis
Phase 2 is completely dependant on the accuracy of Phase 1.
For most of our clients, we are handling the adjusting journal entries and the reconciliations outlined in Phase 1. However, we have clients with high-quality internal accountants for which we can coordinate the review of these items.
In Part 1 of this section, I want to touch on Qualified Tax Deductions & Depreciation via Bonus Depreciation or Section 179 Depreciation. With the tax reform, these forms of depreciation have taken on a new light, so it’s important to highlight them here.
Also worth noting here, if your accountant is not familiar with these deductions, you will want to find an accountant who is.
Qualified Tax Deductions
We are asked common questions: “What can I deduct” or “What is a qualified business deduction?”
The IRS defines qualified deductible expenses as ordinary and necessary expenses incurred in the carrying on of your business. The definition raises more questions.
I commonly think of Ordinary expenses as helping to further the growth and sustainability of your venture. For example, paying real estate taxes on your commercial property will help you sustain your ownership of that property. The same with paying your vendors and employees. Both vendors and employees are necessary for running your business. What likely does not qualify is the vacation you may take to Italy for Christmas with no actual business purpose.
Depreciation and Section 179 Deductions
Most of you have heard of cost segregation studies. We mostly speak about cost segregation studies for newly built properties or recently acquired. While cost segregation studies can be a little costly, they may be worth it. Sometimes, the study isn’t necessary, and we can figure out the segregation on our own.
The goal in a cost segregation study is to identify and separate the assets that have been acquired in a transaction that may be able to be depreciated over much shorter timeframes than the entire building.
A Real-Life Example
For example, if we acquire a property for $1 million, we may be able to identify $50,000 worth of carpeting that may be depreciated and deducted over 5 years versus 39 years. This achieves the ability to speed up deductions and further reduce your taxable income in the current year versus later years.
The time value of money says that dollar for dollar, we’d rather save the money now versus later if all things are held equal.
However, sometimes owners should not speed up deductions if they have other properties generating losses, and there is not much taxable income. Generally, we want to time deductions in years where we have the most taxable income. Or said another way, when we are in a higher tax bracket than in years when we are in a lower tax bracket.
That being said, if we have a significant positive net income, let’s look at how we can speed up deductions. With the 2017 tax reform, and through 2022 we have a new 100% bonus depreciation on eligible assets on acquisitions, new construction, or renovation. Notably, this used to be a 50% bonus depreciation. Also, note the 100% bonus depreciation election gradually declines from 80% to 20% in the 2023 – 2026 tax years.
Bonus depreciation applies to eligible assets. Carpeting, wallpaper, interior glass, cabinets built-in, and a sink in the breakroom are eligible for this 100% bonus depreciation.
Now there are also 15-year land improvements. These are different from building improvements. Land improvements include landscaping, signage, parking lots, sidewalks (generally items that you see outside of the building), are also eligible for the 100% bonus depreciation.
Now for building Improvements, there was a hiccup in the tax reform. A 15-year asset is not eligible for the 100% Bonus, but it is eligible for Section 179 depreciation.
One essential note, though, a Section 179 property can only be depreciated up to the amount of positive net income. In contrast, bonus depreciation can create a loss. Thus, if you have a property loss, we don’t like taking the Section 179 depreciation because it is limited. And, you’re not going to get the immediate benefit of it.
These are just a couple of the deductions to look at when closing out the year.
Tax Budgeting & How to Estimate Your Tax Liability
Next, we are going to discuss tax budgeting and how to quickly estimate your tax liability.
But before we dive into these, I want to go on a slight tangent, about the differences between net income (which your taxes are based on) and cash flow.
Net Income Versus Cash Flow
Frequently entrepreneurs confuse the two when thinking about how much they owe for taxes.
In commercial real estate versus, say, professional services companies (like accounting or law), the differences between net income and net cash flow are different. Additionally, for commercial real estate owners, depreciation is a much bigger deduction. It thus has a much bigger effect (because of all of the capital intensive assets) on the difference between net income and cash flow than for service-based companies.
For example, while we may have $100,000 of cash on hand, we may only have $20,000 of net income for which we’re taxed due to depreciation. Depreciation is often referred to as a paper deduction. Depreciation isn’t actually cash coming out of your pocket.
Similarly, loans and debt also create similar differences between net income and cash flow. For example, when a loan is being paid off in any given year, you may have $100,000 in net income but $20,000 of cash on hand. But, in this case, you’re being taxed on the $100,000. In this case, paying off debt isn’t deductible.
As you can see, cash on hand and cash flow are very different than net income and what you’re being taxed on.
Proactively Estimating Your Tax Liability
How do you estimate your tax liability in any given year?
There are a couple of methods you can use to estimate your tax liability. One is more complex, and one is more simplified. We will go through both.
Complex Method for Estimating Your Tax Liability
The more complex method of estimating your tax liability is also the most accurate. To do this, you essentially proactively prepare a full tax return with all of the information that you have for the coming year. Most of the time, your CPA can do this.
For example, if it’s June of 2020 and we want to know what our 2020 tax liability is looking like accurately, we’ll roll over all of the prior year’s information. From there, we will adjust for any changes to prior year investments and sources of income and expenses that we know we have had in 2020. Plus, we will add any new acquisitions or disposals of assets and sources of income from 2020.
In this example, we’re doing this in June with some assumptions about what will happen for the final 6 or 7 months of the year. But if we have a business with large swings of income, we could adjust this every quarter for the actual performance.
Keep in mind, this isn’t something you want to do yourself. You want to engage your accountant to help.
Simplified Method for Estimating Your Tax Liability
In the simplified method for estimating your tax liability, we’re not preparing a whole tax return. Instead, we are making a whole lot of projection.
The simplified method is best used if there have been very changes in the amounts and sources of your companies’ net income and properties from the prior year.
In the scenario, you look at your prior-year tax return and divide your taxable income by your total tax calculation. With this information, you’ll come to your effective or average tax rate across all marginal tax brackets.
If you are looking at the 2019 tax forms, you can find the Taxable Income amount on line 11(B) on page 1 of Form 1040.
Next, locate your Total Tax amount. This is found on page 2 of Form 1040 on line 16.
Again, this is the simplified method and is a way to accomplish a quick calculation for budgeting purposes. As a note, please consult with your tax accountant for your specific situation.
After we’ve established what our estimated tax liability is going to be, we recommend moving those funds into a separate checking account. Then, those funds are out of sight and out of mind, and you are prepared for any tax payments.
Estimated quarterly tax payments are due on April 15, June 15, September 15, and January 15. We recommend you add these dates to your calendars.
Moving On to Growth
At this point, we’ve covered stabilizing and analyzing in the first two phases. Now it’s time to go to the 3rd phase of planning, which uses the data to make more money and maximize cash flow.
When you’re profitable, budgeting for your tax liability is a real cost that has to be paid to the Federal and State governments. And it needs to be done promptly. We want to avoid paying massive amounts of penalties and interest.
It is very common to see owners in commercial real estate reinvesting every dime that has been made back into the business. Then, the next thing we know, we have a tax problem. Especially if there is an economic downturn as we saw in 2008. Owners had very little cash on hand yet large tax liabilities from the prior year. That is why it is critical to work with your accounting team for guidance to monitor your tax situation. This is particularly true, the faster and larger you grow.
Phase 3 – Grow
With that, I’ll share a story of a recent client.
The client is in the mortgage refinancing business. I received a frantic call from the client. He felt like he “was swapping dollars.” In other words, cash was coming in and going right back out.
He said, “Trevor, man, I’m a sales guy, I know how to close the deal, and then I’m onto the next. I don’t know what these numbers mean.” At the time, we were just doing his bookkeeping and tax work, and so he said, “Man, let’s Activate the CFO consulting (Phase 3) side of things. I’m hurting.”
Long story short, we helped him grow his bottom line significantly. He was able to increase his cash take home by another $20,000 per month in just 45 days.
How did we get there?
Breaking It Down
Our first step was to analyze his sales and marketing efforts. We wanted to know what was driving his sales and what were the associated costs. He had significant advertising spend. We began by analyzing the return on investment (ROI) of each of the mediums where he was advertising. Quickly, we determined that one of these platforms, for every $1 he spent, generated $15 in gross revenues. A 15:1 ROI. That’s ridiculously awesome.
As you can imagine, we froze spending on each of the other platforms and re-allocated all of the advertising budgets to just that one platform.
The second step was to analyze his other sales costs. When he started the company, he gave a sweetheart deal to his Vice President (VP) of Sales. The VP’s compensation was 20% off the top of all gross revenues, regardless of whether the VP’s team even closed the deal. The structure allowed for this gentleman to receive 20% of all deals whether he was involved or not.
In actuality, the sales guy was making more cash than the owner. And was doing so without any of the risk or any of the expenses. Thus, our second step was renegotiating the compensation plan. The new plan was more aligned with the VP’s sales role.
What The Analysis Found
In total, these two steps alone resulted in an additional $20,000 per month in his pocket. That was analyzing the sales and marketing part of his budget. We had not even begun to dive into the true operating structure of his operations.
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Final Notes to Close Out The Year
We hope this information helps you close out your year, right! As you have seen, the reality is, it’s best to stay on top of your finances all year. Here is a final checklist to help you close out the year right for your real estate business.
Download your free PDF checklist for closing out the year.
About Trevor McCandless
Trevor McCandless is a native of Jacksonville, Florida, with over 10 years of experience. He earned his Bachelor of Science degree in Accounting from the University of Florida. After moving to Atlanta, he attained his Master of Taxation degree from Georgia State University. He formed Fusion CPA because of his career in tax planning and compliance for small “closely-held” businesses and their owners combined with his passion for building successful businesses. He specializes in tax translation.