The purpose of having a good bookkeeping system in place for your real estate business is not only for tax compliance but also for becoming better informed to make any important financial decision. When you know the exact status of your portfolio and the performance of each property at any time, you will be in a better position to make more strategic moves in your investment or personal life.
Per IRS standards, all receipts over $75 should be kept. Fortunately, you don’t necessarily have to keep the paper receipts, a digital copy of the original receipt would satisfy this requirement too. Many self-managing investors make the mistake of not keeping the receipt copies, and thinking a bank statement would be sufficient as the support material. This is absolutely not true and it is important to keep those records for up to 7 years in case of an audit.
Some rental management software automatically tracks your bank account spending, and you can later categorize each item. However, unless you keep or upload the receipts for each expense, such a way of tracking expenses will not be sufficient per IRS bookkeeping standards. Instead, it’s recommended to use a tool that streamlines expense entry along with receipt capture like the one provided through PortfolioBay. Its built-in receipt scanner lets you upload cropped and cleaned receipts in seconds, making it easier to use while maintaining sufficient documentation standards.
Another common issue when investors use rental software that automatically tracks expenses is wrongly labeling the mortgage payment as the mortgage interest payment. The mortgage payment includes mortgage interest and loan principal, and sometimes also includes insurance escrow. Only mortgage interests are tax-deductible, and without knowing the specific financing terms, it’s impossible for rental software to calculate the deductible amount correctly based on the monthly expenses.
Instead of tracking it on a monthly basis, it’s better to wait for the 1098-INT form, which has the exact amount of interest you paid this year, from your lender at the end of the year and make a one-time entry into your bookkeeping system.
This should be super obvious. But in practice, there are some serious hurdles in maintaining the bookkeeping rigors throughout. For example, some advocate having a separate bank account for each property to keep everything separate. But this method is really only good for managing less than a small portfolio. The reason is that to cover all the unexpected expenses for each property, like replacing a water heater or unexpected repairs, some operating funds must stay liquid in each account at all times.
For portfolios with more than 12 units, this method locks up a lot of cash in all these separate bank accounts, because a larger portfolio handles repair and turnover at a more regular interval, thus needing less cash, proportionally speaking, to be set aside to cover those infrequent but large expenses.
Regardless of which bank account each expense is paid out of (personal or business), it’s far more important to capture the detail and purpose of each expense. After all, you just have to justify each expense’s detail and purpose in your bookkeeping.
Newer investors like to look at the cash-on-cash return on a given property and brag about how good of a deal it is. But when we dig a little deeper, we can see that cash-on-cash return is just a mirage and the real underlying performance of an asset is its cap rate. The reason is that on a given property at a certain price, the cash-on-cash return varies depending on a lot of other factors that don’t have to do with the underlying assets, such as the downpayment ratio, and loan interest rate. Cash-on-cash return is a useful metric, but comparing two properties with different interests rate and leverage amounts is like comparing apples to oranges.
The Cap rate reflects the unleveraged return of a property, so, it’s a much more important financial metric when comparing properties in the portfolio. PortfolioBay helps investors to track property cap rates as they manage all their income and expense in the built-in accounting system.
Online payment not only saves a lot of hassle in managing paper checks and enforcing late fees, but it also eliminates any manual accounting ledger updating when integrated with an accounting system. When tenants make a payment online, there isn’t anything that needs to be done by the landlord to record the payment in the accounting system, saving time on every unit every month.
While certain specific real estate taxes and laws may be better assisted by a professional accountant, maintaining a good income expense record in compliance with IRS standards is what every self-managing investor can do!