To get to the core of the article “The Problems and Realistic Solutions to Accounting for Real Estate Companies, ” we need to understand the basic functioning of a Real Estate company. A Real Estate company could be employed in one or several of the following functions:

How does a Real Estate Company work?

The core functionality of a Real Estate Company is to acquire properties, build, develop, or renovate them during project completion. They earn revenue by leasing, renting, or selling. A company might also be a property manager or brokerage firm. A Real Estate Company could perform all of the above functions or a combination of them.  

Real Estate companies may be set up as LLCs, S-Corps, or REITs to optimize tax benefits or limit tax liability. Entrepreneurs may also establish separate legal entities for each project to isolate financial risk.

What are the authorities & regulatory boards that hold a Real Estate Company accountable?

1. Internal Revenue Service (IRS)
2. Securities and Exchange Commission (SEC)
3. State Real Estate Commissions
4. Financial Accounting Standards Board (FASB)
5. Local Zoning and Building Departments
6. Department of Housing and Urban Development
7. Environmental Protection Agency (EPA)
8. U.S. Department of Labor (DOL)
9. Consumer Financial Protection Bureau (CFPB) &
10. Local Housing Authorities

This gives a picture of the complexities of the very functioning of a Real Estate Company. An accountant who isn’t trained in the industry could go in circles trying to figure out the specifications. Here’s why  

Why is Accounting for Real Estate complex?

Multiple regulatory authorities govern Real Estate in the US. When it comes to taxation, a firm complies with a blend of Generally Accepted Accounting Principles (GAAP) and Internal Revenue Service (IRS) tax codes.

Common issues arise from:

• Revenue Recognition
• Misstated lease obligations
• Capital and Expense classifications
• Improper tax depreciation schedules
• Mishandled 1031 exchanges or cost segregation
• Confusion between capital and repair costs & more

1. Revenue Recognition

Problem: Incorrect timing or method of recognizing revenue.

Real Estate companies observe ASC 606 to recognize revenue from service contracts and sales. Revenue is recognized only when the buyer obtains control, as per the payment terms and closing conditions.

Leasing typically follows straight-line rent accounting, which recognizes rent escalations and incentives over time—even in practice, cash isn’t received in that manner. – under ASC 840/842.

Solution:

• ASC 606’s Five-Step model acts like a handbook you can use to create a contract review checklist
• Train your Accounting Executives to distinguish between performance obligations in sales and leasing
• Adapting to software solutions tailor-made to the Real Estate Industry is a big plus

2. Lease Accounting

Problem: improper classification of accounts for leases.

As of 2019 (public companies) and 2022 (private companies), ASC 842 mandates all leases to be reported on the balance sheet as Right-of-Use (ROU) assets with corresponding lease liabilities. Having to record most leases on the balance sheet makes accounting more tricky.

• Adding to the complication is the fact that most Real Estate firms function as lessees (tenants) and lessors (landlords), creating complexities in lease classification and disclosures.
• Operating vs. finance lease classification also affects profit and loss differently.

Solution:

• Enforce a centralized lease database with terms, renewal options, and escalation clauses.
• Use ASC 842-compliant lease accounting software like LeaseQuery or Visual Lease.
• Reassess all lease contracts and educate finance teams on ROU assets and liabilities.
• Train your staff to use the centralized data base and the software with the right terminology and help them comprehend clear classifications.

3.  Capital vs. Expense Misclassification

Problem: Segregating capital improvements from repairs and maintenance can be confusing.  

As per the IRS and GAAP rules:

• Capital improvements must be capitalized and depreciated &
• Repairs and maintenance can be treated as expenses.
• Determining whether or not a cost is a capital improvement or a repair/maintenance expense can be judgment-heavy. Misclassification can distort profits or lead to tax penalties.

Solution:

• Develop a capitalization policy that defines, without doubt, capital vs. repair expenses based on IRS and GAAP guidance.
• Property improvement projects should implement an efficient cost tracker with approval-based workflows to avoid confusion.
• Undertake frequent reviews with an accountant to audit classifications.

4. Depreciation & Cost Segregation

Problem: arises when depreciation benefits are not maximized because of incorrect schedules.

• Residential properties are depreciated over 27.5 years, while commercial properties are depreciated over 39 years as mandated by MACRS (Modified Accelerated Cost Recovery System).
• Improvements may follow different schedules. i.e. Cost segregation studies can accelerate depreciation on specific components (e.g., lighting, carpets), to avail tax advantages early on.
• The land isn’t depreciated; separating land from building costs is crucial.

Solution:

• Take assistance from a cost segregation specialist to separate short-life assets (5, 7, 15 years) from long-term ones.
• Maintain an asset ledger with IRS-classified depreciation schedules (MACRS), which can be used as a reference.
• Review and update depreciation entries annually to reflect asset retirements differently from improvements.

5. 1031 Exchange Mishandling

Problem: Missing the cut-off dates or improper documentation.

• According to section 1031 of the U.S. Internal Revenue Code, the state allows a deferral of capital gains taxes on the condition that property sale proceeds be reinvested in a similar property.

These must be reported as per strict IRS deadlines, i.e.,45-day identification & 180-day closing.

Solution:

• Hire a qualified intermediary (QI) to assist you with 1031 transactions.
• Use a calendar-based compliance tracker for 45-day and 180-day deadlines.
• Adhere to detailed records of purchase and reinvestment agreements for tax filings.

6. Construction-in-Progress & Development Cost Tracking

Problem: Incorrect capitalization or cost tracking of ongoing projects.

All costs when the project is on-going must be capitalized under GAAP, eg; labor, materials, permits, loan interest etc.

• Once the project is completed and set in place for service, it should account for depreciation.
• Revenue recognition for projects under contract may follow percentage-of-completion or completed contract methods, depending on terms and type.
• Tracking costs for incomplete projects and properly capitalizing them calls for accurate project accounting.
• In some scenarios, revenue may be deferred for years, whereas cash is spent upfront.

Solution:

• Use accounting software designed for Real Estate (e.g., Procore, Sage 300 CRE) to record actual and budgeted costs.
• Capitalize only directly attributable costs, such as labor, materials, and interest, as per GAAP.
• Close CIP accounts and begin depreciation only once the asset is in service.

7.  Entity Structure & Consolidation Issues

Problem: Wrong financial reporting across several entities.

• U.S. companies tend to use LLCs, LPs, REITs, or holding companies for asset protection and tax efficiency. Isolation of project-wise entities help limit liabilities as well.
• However, each entity has unique reporting requirements, making consolidation under GAAP (ASC 810) a herculean task.

Solution:

• Utilize and trust accounting systems with multi-entity consolidation capabilities (like Yardi Voyager or RealPage).
• Ensure compliance with ASC 810 (Consolidation) to reflect control relationships appropriately.
• Consult a CPA who is experienced in multiple REIT structures.

8. Debt Compliance and Loan Covenants

Problem: Breaching loan covenants unknowingly.

• Real Estate firms often operate with significant leverage and have to maintain debt service coverage ratios (DSCR), loan-to-value (LTV) ratios, and covenants tied to GAAP financials.
• Falling short of these covenants can trigger defaults even if the firm is cash-positive.
• A profitable business could go into loan default if the company fails to maintain these ratios.

Solution:

• It’s indispensable to monitor loan covenants on a monthly basis using KPIs like DSCR and LTV.
• Build automated alerts in your financial dashboard if ratios are at risk.

9. Valuation and Fair Value Gaps

Problem: misreporting asset values based on GAAP rules.

• U.S. GAAP requires Real Estate Companies to record properties at historical cost, not fair market value
• This makes financial statements conservative when the company needs to approach investors or other stakeholders. In most other scenarios, fair value accounting is beneficial.
• Properties are revalued regularly, creating valuation subjectivity, potential earnings volatility, and the need for professional appraisals means they regularly revalue properties.

Solution:

• Perform annual third-party appraisals with a seasoned expert and disclose details of fair value and historical costs.
• Disclose market value changes in footnotes while continuing to report at historical cost, especially for taxation purposes.

What are some General Best Practices to avoid mistakes in Real Estate Accounting?

1. Hire an outsourced accounting firm or real estate accounting services specialized in the complexities of Real Estate Accounting. A general accountant may not be aware of the intricacies of the workings of US Real Estate.
2. Conduct quarterly reviews and plan your tax strategy for each accounting period. Quarterly reviews help avoid year-end surprises and help compare actual financials with forecasts.
3. Most of the above stated problems needed a tech solution! Alerts to keep solvency ratios in check, segregation of incomes, clear project status and unique depreciation treatment as per the project status. Like all accounting requirements, Real estate accounting is also subject to manual errors, people’s perception and the possibility of overlooking vital details that could lead to penalties. Investing in a robust software solution could save more in the long run.  
4. Maintaining accurate documentation & Audit records and classification into a time and function-based system is vital. Real Estate Companies are answerable to several stakeholders, namely the IRS, clients, state tax boards, and investors.  Develop internal KPIs to track lease terms, project completion status, relevant tax rates, etc, to make sure you don’t miss out on important checkpoints.
5. Train Internal Staff Regularly, starting from data entry, accounting executives, project heads, to every division that holds significance to any form of reporting should be trained in relevant details to minimize errors and ensure strict adherence to guidelines. Conduct training programs frequently to ensure accuracy.

Some Recommended Software for Real Estate Accounting:

• Yardi, MRI Software
• Buildium, AppFolio &
• QuickBooks Online with Real Estate Plugins

Key Takeaway: 

Accounting for Real Estate is a complex activity; industry leaders and top executives do not have the time to value and revalue properties, conduct repetitive audits, and review taxes frequently within one accounting cycle, although the guidelines demand such involvement. Companies can feel safe entrusting a professional accountant or CPA to look into it. Profitjets can handle the conflicting complexities of the Real Estate Industry and help you comply with GAAP, IRS, and other relevant authorities using efficient software that is tailored to your needs.