Report on a presentation made by Michael Plaks on August 30, 2005
Written by Bob Bartel of UPOA. Reprinted with permission.
The more you invest in different forms of real estate, the more complicated your taxes become. Whether or not you do your own taxes, there is one thing of utmost importance … good record keeping. Neither you nor your accountant can competently do your taxes without a good system to record income and expenses. But keeping good records is even more important than keeping out of trouble with the IRS. It can be the difference between paying more than you need to and, ultimately, making your business successful – or dooming it to failure. A good accounting system gives you a yardstick to measure your success and a tool to tweak it to perform even better.
To help us understand the essential elements of good bookkeeping, UPOA member Michael Plaks took center stage. Michael is a federally licensed income tax advisor, specializing in Real Estate taxation. Here is what Michael had to say. “From where I sit, it appears that most investors either have no bookkeeping at all, or they use some home-made form of bookkeeping that, at best, serves as duct tape for a plumbing leak. And what exactly is leaking? YOUR money! Does it mean that everyone needs to master QuickBooks™ and hire professional bookkeepers? I don’t think so.”
The hardest part about bookkeeping, according to Mr. Plaks, is doing it regularly. It is better to use a simple system on a daily basis to keep track of expenses than it is to invest in a complex professional system that only gets used once a month or even worse, just at tax time. Part of what seems to make record keeping complicated to us is that we actually look at the numbers we record from three different perspectives.
The bookkeeper asks, “What was paid, to whom, and when.” He is looking for a strong balance sheet. There is little interpretation of the data, and it is done primarily for tax purposes and for outside investors. The tax accountant is only needed once a year to seek out as many expenses as possible. His job is to reduce taxes, but he doesn’t look at the real cash flow picture. That’s the job of the investor. He or she is looking for a good deal. The investor is interested in the month to month picture. This is where the analysis comes in: checking Return on Investment (ROI), Cap Rate, and Cash Flow. To run a business, one must look at all three aspects of money: day to day credits and debits, the big picture of where the money is going and how fast, and the nitpicking of what is an expense, vs. what must be amortized, and how to deal with tax law effectively.
Michael’s “three keys to decent bookkeeping without losing your sanity” are to
- Record everything
- Do it regularly and
- Keep all records in one place.
To make the job easier, he suggests separating all expenses by property and assigning categories to each expense. A program like Excel™ or Quicken™ will assist you in this endeavor, but don’t invest in a complicated system like Quickbooks™ unless you have an accounting background, or are willing to take the time to take classes to learn the necessary terminology and concepts involved.
One additional suggestion that Michael made to try to simplify our individual accounting is that, when doing tax calculations, we must ignore financing and our personal contribution in buying a property. Rather, we should look at the total costs of the deal including loans used, as if the entire transaction was done in cash. As an example: if you, an investor, put $10,000 into a deal which you later sold and made $20,000 on, you would have gained $10,000 or made 100% profit. But from an accountant’s perspective, you must take into account the total cost of the property, including the $75,000 loan you took out, $3,000 in hard money interest, and $2,000 in taxes which you paid in order to close the deal.
Another tip from Michael was in dealing with escrow payments. They should be accounted for separately, because these cannot be deducted at the time they are made. They only become expenses at the time a payment is made out of the fund for taxes, insurance, or whatever the fund was being held for.
Michael also helped clarify the distinction between being a real estate dealer and having rental properties. The dealer is a reseller of inventory, much the same as a car dealer. All property is considered inventory so there is no depreciation or long term capital gains. The basic difference is in intent; not how long you hold a property, or how many properties you sell in a year. If you are classified as a dealer, you may not claim rental tax breaks even if you end up renting a property that you can’t turn over quickly.
Michael concluded by reminding us that if we do make a mistake, we have three years from the time we filed a return to correct a problem. Making corrections should not create confusion or increase our chances of an audit, because, in general, the IRS is 1 to 2 years behind in reviewing returns.