What Is Cash Basis Accounting — and Is It Better Than Accrual?
We get it — rental property accounting doesn't exactly sound like a thrill ride. As a landlord, you'd probably rather spend time finding great tenants and learning how to boost your investment returns.
But, stay with us here: getting your accounting basics locked down early is pretty important for the long-term survival of your rental property business, especially as your portfolio grows.
Simply put, the accounting method you use shapes how you see your rental business finances day-to-day and where you focus your energy.
In this guide, we'll talk through the decision between cash basis and accrual accounting in simple terms, using real examples relevant to small-time landlords like you. We'll break down the differences and explain what each method shows you. You'll walk away being able to make the best choice for your investing objectives.
Sound good? Let's get to it, then! Here's everything landlords need to know about property accounting methods.
Understanding cash basis accounting
Cash basis accounting records financial transactions based on actual cash inflows and outflows. You recognize revenue upon the receipt of cash and record expenses when you pay them.
This simpler accounting method works well for real estate business finances, since it captures the financial impact of transactions as they occur. By tying the books directly to cash movement, it provides a clear picture of cash flow.
Cash basis accounting is especially suitable for smaller businesses who deal with straightforward financial transactions.
What is accrual basis accounting?
Accrual basis accounting records financial transactions based on when you earn revenue and incur expenses. With this approach, you log revenue and expenses when a transaction occurs or you've signed an obligation, which may be different than when money actually changes hands.
As a landlord, how do you decide which one to pick? Let's explore questions you might ask to determine which method is best for your real estate business.
Timing of recording transactions
When should I record rental payments coming in late?
Let's say a tenant pays 3 months of back rent owed. With cash basis accounting, you would record the full lump payment when the cash clears your bank account.
With accrual accounting, you would have recorded revenue month-by-month on each rental due date per the lease agreement, regardless of when the actual payment arrived from the tenant.
Focus on cash flow
My tenants often pay late. Which method best tracks the impact?
Cash accounting directly mirrors when money enters or leaves your bank account.
Using the accrual method would show owed rental income on your books by the due date, even if the tenant check didn't clear the bank until 2 weeks into the next month.
Accurate financial performance
I have one tenant who always pays late but shows as profitable under cash accounting. What gives?
Accrual accounting matches revenue and expenses to appropriate time periods, regardless of uneven payment timing from particular tenants. Since there is a cost for landlords when a tenant doesn't pay on time, this approach presents a more precise profitability picture.
Financial statement presentation
I'm not an accountant. Which method is simpler to understand?
Let's say you only own one single-family rental property. The cash accounting income statement would clearly show rental income deposited and expenses paid out month-by-month.
Accrual accounting method statements incorporate more accounts receivable and payable figures, like rent owed but not yet paid by the tenant or property tax bills not yet settled.
I have 5 rental properties. Can I choose my preferred tax method?
As long as your rental portfolio generates less than $25 million in annual revenue, you can elect to use either the cash or accrual accounting method for tax reporting purposes. Be sure to verify with an accountant which approach optimizes your situation per IRS rules.
How much paperwork is involved here?
The cash method has simpler documentation needs — primarily bank statements showing cash received from rental payments and expenses paid out.
The accrual system requires you to record additional accounts receivable and payable figures, which have more involved bookkeeping steps.
Advantages and disadvantages of each method
Now that you have an understanding of some of the key differences between the two methods, let's cover the pros and cons of each:
Pros of cash basis accounting
- Simplicity: Cash basis accounting is straightforward to understand. It requires minimal accounting knowledge and record-keeping, making it suitable for landlords who have small businesses and simple financial transactions.
- Real-time cash flow visibility: With cash basis accounting, you can immediately see the inflow and outflow of cash. It can be beneficial for monitoring day-to-day cash management and making sure you have sufficient funds to cover expenses.
- Tax benefits: The cash basis method can provide tax benefits at year-end. If tenants pay late in December, you account for the income in the following year. It can effectively spread your taxable income over time, potentially lowering your tax obligations.
Cons of cash basis accounting
- Limited financial insight: Cash basis accounting does not provide a perspective of your real estate business's financial performance. It fails to consider revenue earned but not received, giving an inaccurate representation of profitability.
- Inaccurate timing of expenses: Since cash basis accounting records expenses only when you pay cash, it may not align with the actual timing of when you incur expenses. It can distort financial statements and mask the true cost of operations.
- Non-compliance with GAAP: Cash basis accounting may not comply with Generally Accepted Accounting Principles (GAAP) in some jurisdictions. Larger real estate businesses or those seeking external financing may be required to follow accrual basis accounting to meet reporting standards.
Pros of accrual basis accounting
- Accurate financial performance: Accrual basis accounting accurately represents your business's performance by aligning revenue with the related expenses. It allows for better assessment of profitability to help you make future business decisions.
- Conforms to GAAP: Accrual basis accounting adheres to GAAP, which makes it a good choice if you need standardized financial reporting for external financing.
- Long-term planning: Accrual basis accounting helps you to forecast future cash flows and plan accordingly. It provides a more comprehensive view of your financial position over time.
Cons of accrual basis accounting
- Complexity and record-keeping: Accrual basis accounting is more complex than cash basis accounting. It requires diligent record-keeping, adjustments for accruals and deferrals, and a solid understanding of accounting principles.
- Delayed cash flow recognition: Accrual basis accounting may result in a mismatch between the timing of cash flows and the recognition of revenue or expenses. It can impact cash flow management and create potential cash flow challenges, especially if your tenants consistently pay late.
- Potential tax implications: Accrual basis accounting may lead to earlier recognition of income, potentially resulting in higher taxable income and tax liabilities, even if you haven't received the corresponding cash yet.
Which method do most landlords use?
The majority of small-scale landlords and real estate investors use the cash-basis accounting method to track their properties. Beyond the simplicity and cash flow clarity, there are a few other advantages that make it appealing:
- Flexibility around recording income replacement expenditures: Cash basis allows landlords to time when they classify certain major repairs as expenses to match against rental income. This provides more control over tax planning.
- No need to account for accounts receivable/payable: Avoiding tracking and documenting receivables/payables between reporting periods is simpler for landlords managing just a few properties.
- Handling occasional rental gaps: If a property sits vacant for a period, accrual accounting would create losses unrelated to actual cash inflows/outflows. The cash method avoids reflecting these losses on paper.
While large REITs may utilize accrual basis, cash accounting benefits basic tracking for individual investors.
Best practices for cash accounting
If you decide to use the cash accounting method, there are some best practices to help you comply with financial reporting requirements. Here are our tips:
- Consistency is key: Once you have selected cash-basis accounting for tax filing purposes, be sure to keep this accounting method moving forward. The Internal Revenue Service (IRS) recognizes the initial method you use for tax filing, and if you want to make changes, it requires approval from the IRS.
- Include all received funds: Under cash accounting, you should include all funds received during the tax year in your gross income, which is easy enough when you directly collect rents. If your rental property has a property manager that receives rent payments on your behalf, you should report the rent as income when the property manager receives it, not when it clears your bank account.
- Account for goods or services instead of rent: If your tenants provide goods or services instead of rent payment, you must include the fair market value of those goods or services as part of your reported income to ensure that you're accurately reflecting the full value of the transaction.
- Advance rent payments: In cases where tenants make rent payments in advance, include the advance payment in your rental income for the year you receive it, regardless of the period it covers. This provides proper recognition and tracking of rental income.
- Security deposits: Typically, you wouldn't count security deposits as income if you plan to refund the tenant at the end of their lease. Two exceptions to this are if you use the security deposit to cover the last month's rent or if you need to apply the security deposit to cover tenant damages.
Cash basis accounting for rental property
So, there you have it, the low down on picking between cash and accrual for your real estate business. It mostly comes down to what financial lenses help you run your rental business without distraction. Cash accounting lets you focus simply on the cold hard cash flowing in and out each month, whereas accrual shows a bigger picture of what tenants owe versus what the landlord owes others.
Whichever route you go, just be sure it matches your investment style and tax situation right now. As your property empire grows, you can switch accounting methods down the road. Just be sure to get the IRS's approval first to avoid even more tax paperwork raining down on you. For now, though, choose the financial vision that lets you focus on the more strategic aspects of your real estate business.
What is cash basis accounting? FAQs
Are there any legal requirements to use either method?
Legal requirements, such as tax regulations, may influence your choice of accounting method. Some real estate businesses may be required to use accrual accounting for tax purposes, while others may have the flexibility to choose between the two methods.
Can I use a combination of cash and accrual accounting methods?
Yes, you can use elements of both cash and accrual accounting methods, but experts generally recommend sticking to one method for consistency and clarity in financial reporting.
Can I change my accounting method once I have chosen it?
While it is possible to change your accounting method, it may require adjustments and additional paperwork. Consult with a tax professional to understand the implications and requirements of changing your accounting method.