Where are you looking for answers?
Remember this old joke where a late night drunk is crawling on his knees around a lamppost, in circles? Responding to an inquiry from a passer-by, the man explains that he is searching for his watch.
– So, you dropped your watch under this lamppost?
– Oh no, I dropped it down the alley, but it’s too dark over there, so I’d rather look under this bright light.
Now, I’m not implying that real estate investors have a drinking problem, but it does seem that many of them are searching for answers in all the wrong places – just because these wrong places are well-lit. What answers am I talking about? Answers about bookkeeping and taxes.
For example, every investor heard that proper bookkeeping requires QuickBooks software. And, to save on taxes, you must create LLCs and corporations – the more the better. These are good examples indeed. Examples of well-lit lampposts that will let you crawl around them in circles forever, never finding what you’re looking for.
See, the answer to saving big bucks on taxes is not in setting up fancy business structures. The answer is too simple for some folks to take it seriously: keep good records!
Not sure how recordkeeping saves you money? Let me illustrate. Brian, a client of mine, is fixing and selling houses, like many of you. Every year we have the same conversation at tax time.
– So, Brian, how much money did you put in this rehab?
– Well, you know, I don’t keep all receipts, but it was at least 10 grand, I’m sure. No, wait a second, I forgot about the foundation. Make it 12 grand. Maybe even 13. Yeah, let’s put down 13. Or maybe 14, I’m not totally sure.
Sounds familiar? Suppose that Brian underestimated his true rehab costs by a mere $1,000. Sounds harmless, compared to his entire business? It’s not. This relatively small $1,000 oversight will cost him $400 in totally unnecessary taxes! $400 of hard cash flying out of Brian’s pocket into the government’s. If Brian’s estimate was $2,000 short – he is flushing $800 down his brand new toilet. With $5,000 of “forgotten” expenses, he is wasting $2,000 – two thousand dollars!
Ironically, Brian will often spend two days getting competitive bids from contractors, so he can save $400 on labor. And then, in one stroke of generosity (or stupidity if you will), he will blow several times as much by failing to keep simple records. And to whom does he “donate” his cash, out of all charitable causes? To the IRS! Do you see my point now, Brian?
Like it or not – this is about bookkeeping.
Fine. Let’s go buy QuickBooksand convert our shoeboxes full of receipts into computer- sponsored paradise, agree?
Maybe not. The only “quick” thing about QuickBooks is that it’s very quick to mess up. Before I’m lynched by the angry mob of CPAs and accounting-savvy investors, may I clarify myself, please? I am not against QuickBooks – it is an excellent product for professional-grade accounting, possibly even the best in its league. The problem is that using professional-grade anything can be expensive, time-consuming, and even dangerous. Not to mention unnecessary.
Think about power tools. I’m sure you can recall stories when these excellent tools did more damage than good. There’re some funny TV commercials about “tools for real men”, by the way. In the trained hands, for the right job, these tools can be life-savers. However, beware the amateur handyman with a powerful drill. I have some holes in my ceiling, to prove this point. Don’t ask.
Same story with QuickBooks software. It’s great – IF you have a big enough business and willing to invest a lot of time in learning how to use it properly. Don’t be fooled by the fact that this software is produced by a company named Intuit – it is anything but “intuitive.”
Well, if you’re not yet ready for QuickBooks (and most beginner investors are not) – then what? To find the answer, we need to walk down that dark valley of the IRS rules. Because, as you know, it’s the IRS who we need to please in the end.
What do you want from me, the IRS auditor?
She wants you to prove that you did spend as much as your tax return says you did. Somehow, swearing does not convince her. Neither does the fact that your bank account is overdrawn. She wants “records.”
“Records” is a very important concept to understand. It is not the same as “receipts”, “books” or anything else. To satisfy the IRS, you need an itemized list of every business expense. Most importantly, each line on this list must include 4 things:
- Amount – how much was paid
- Date – when it was paid
- Payee – who it was paid to
- Purpose – what it was paid for
2 out of 4 are not enough. 3 out of 4 are not enough. You must have all 4. Besides, in addition to these 4 elements, the IRS wants you to prove that you actually did make all payments.
Sounds simple enough, doesn’t it? Yet, this 5-part fundamental requirement clearly shows that most of us are doing poorly in this area.
For example, let’s assume you do have this 4-part log, in an Excel spreadsheet. Is it enough? Nope. Must prove that your list is honest – that you paid all of this money. Better have bank statements or cancelled checks. After all, nowadays any kid can manufacture an Excel table, and you cannot blame the IRS for being suspicious.
Can you rely on bank statements and credit card statements exclusively? Not really, because they’re missing the 4th item: business purpose. And if it’s been awhile, you may also have trouble with the 3rd item: who it was paid to, since that usually requires a copy of the check itself.
How about invoices from contractors and vendors? No. They usually do not show when you paid this invoice (item 2), or whether you paid it at all. Carbon copies from your checkbook? Not again. Copy of a check does not prove the check was paid (mailed out), unless you have a cancelled check.
What’s left? The favorite weapon of every investor: shoebox full of receipts. Now the IRS must be happy, right? Wrong! Receipts do not indicate business purpose (item 4), not to mention that they’re messy and incomplete. I can guarantee that your shoebox does not have ALL the receipts. Besides, if you ever shopped at Home Depot, you know that these receipts fade out in a few months and become totally useless.
Arrgghhh! Is there anything that pleases the IRS?!?
Actually, there is. You need a combination of two documents. If you have both – your IRS auditor should be happy. Well, if not happy, at least not too grumpy.
First is a detailed log of all business expenses, containing the four elements I listed above: how much, when, to whom, and what for.
Second is a complete set of bank and credit card statements proving that payments were made.
That means no need to keep receipts?!? I did not say that. Receipts will make your defense much stronger, and the IRS simply loves to see them. Even more importantly, receipts will be your lifesaver if you did not keep that darn log. And honestly, did you?
What I did say was that receipts by themselves are no good, especially if they are “kept” on your truck’s floor, somewhere between last year’s Greensheet and soiled hamburger wrappers. To survive an IRS audit, you better have a good expense log and good bank statements. Receipts are nice extras, not your primary defense.
And speaking of faded and misplaced receipts, here is a 21st century solution: buy yourself a flatbed scanner. Scanned computer files do not fade. Just make sure you keep a backup. Trust me: it’s only a matter of time until your computer crashes.
OK, I got it. Now, how do I go about keeping this expense log?
That depends on your personal preference. If you’re a computer person, you can use Microsoft Excel to set up this log. Alternatively, you can use one of the two competing money management products:Quicken from Intuit (same company that makes QuickBooks which I discussed in the beginning) or Microsoft Money. Both products do a good job, are very easy to use, and one of them usually comes free with your new computer.
Your iPod, Blackberry, or whatever electronic marvel they will sell you tomorrow, should include some kind of expense tracking utility. It’s great, provided that you can print out that list if needed and that you never lose your expensive toy. Also, freeway is not a safe place to be entering your expenses, unless it’s late afternoon on 610 around the Galleria.
Don’t feel inferior if you’re not up to speed with computers and other technology. Pencil and paper still work. As a matter of fact, they often work better. There is something mystical about writing things down that makes people more disciplined. Maybe computers have too many distractions?
Whatever you choose – be it an old-fashioned yellow notepad with a ball pen, the trusted Excel, or some virtual whatever software – it’s not about what you use. It is about HOW you use it. More specifically, how regularly you use it.
Here is the secret that software vendors hide from you: expense tracking software is useless if you do not record expenses at least once a week, and preferably every day. Our memory, like Home Depot receipts, tends to fade quickly. And there are no scanners and no backup drives. Once forgotten, it’s forgotten. Just ask Brian, my rehabber client who I introduced to you earlier.
If you decide to stick with hand-written logs, please visit my website and click on “organizers.” You can see a sample audit-proof log. Besides, I designed some nifty pre- printed logbooks that are very popular among my investor clients and students.
Do I need to organize my expense log into some categories?
Categories can be helpful, but they can also backfire if you use them wrong. You may want to ask your accountant about the categories he wants you to use. If not sure – you can postpone this task until the tax time.
There is, however, another sorting chore that you, as a real estate investor, better start doing right away: record expenses separately for each property. This habit of by- property separation will save you a lot of time and money down the road.
How do you do that? Very simple. If you use Excel – create one tab per property. If you use paper tool, such as my custom logbook, assign separate pages for each property. That’s all there is to it! .
Almost all. Some of your business expenses are general in nature, meaning not linked to any particular property. I’m talking about expenses like advertising, tools, computers, office supplies, accountant fees, education, cell phone, driving – anything that is for your business as a whole and not for one specific property. We call such expenses ‘business overhead.” How do you track these expenses? You guessed it – simply allocate one more page (or Excel tab) and label it “overhead.”
What about gas and other automobile expenses?
They are business expenses, too. Accordingly, you need to log them just like you do with building materials and office supplies. Record everything: gas, oil changes, auto insurance, tires, inspection stickers. An important tip: do not try to separate “business” gas from “non-business” gas. Record everything, and let your accountant deal with allocation.
Here is the most important thing you need to know about business driving: the IRS always wants to see your mileage log. Yes, even if you keep track of gas and maintenance, you still need to keep track of business-related miles.
Remember the four must-record elements for the expense log? There are some required elements for the mileage log as well. The minimum is three:
- Date – when did you drive somewhere for business
- Amount – how many miles was it
- Purpose – why did you have to drive there
Want to see a sample? My website shows a sample mileage log if you click on “organizers”, and my custom logbooks include IRS-compliant pages for logging mileage.
Isn’t there a simpler way?
There is, of course. My client Brian discovered it long ago. It’s called – overpaying the IRS.