Real estate developers typically utilize the federal income tax basis of accounting to prepare their internally generated financial statements. Developers often have an in-depth knowledge of their financial position in accordance with the federal income tax basis of accounting. However, when developers enter into certain agreements, such as a financial agreement with a municipality as part of the Payment in Lieu of Taxes (PILOT) program or a lending agreement with a bank, the agreement may require financial statements that are prepared in accordance with Generally Accepted Accounting Principles (GAAP). It is important to understand the differences between the two methods as you enter into these agreements since they often yield substantially different results.
Methods of Accounting
The Federal income tax basis of accounting is the basis of accounting that a company uses to file its federal income tax return. It is based on the same federal income tax laws found in the Internal Revenue Code, as well as related revenue rulings, regulations, and procedures. The federal income tax basis of accounting allows entities to choose a cash basis or accrual basis. On a cash basis of accounting, revenues are recognized when cash is received, and expenses are recognized when they are paid. On the other hand, on the accrual basis of accounting, revenues are recognized when they are earned, and expenses are recognized when they are incurred.
GAAP is a set of rules, guidelines and principles that are established by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). The first key difference between the federal income tax basis of accounting as compared to the GAAP basis of accounting is that all financial statements prepared in accordance with GAAP are required to be prepared on an accrual basis of accounting.
Key differences
When reading the financial statements of an entity it is important to understand the method of accounting that is being used to report the financial activity. There are many differences between the federal income tax basis of accounting and GAAP and the financial statement results could be drastically different.
The chart below details some of the key differences between the two methods of accounting that may impact a real estate entity.
| Topic | GAAP | Federal Income Tax Basis |
| Rental income and rent expense | Operating leases with a term of more than 1 year are recognized evenly over the term of the lease on a straight-line method. | Lessors recognize income when it is earned or paid, whichever comes first. Lessees expense the rent when payments become due, if accrual basis is used, on a cash basis rent expense is recognized when paid. |
| Advance payments | Included as a liability on the balance sheet as deferred revenue. When the advance payment is earned, it is then recognized as revenue on the income statement. | Advance payments are recognized as income upon receipt provided there is no restriction on the use of the funds. |
| Bad debt expense | Management is required to evaluate accounts receivable, no less than annually, to determine an estimate of accounts receivable which, may not be collectible. This estimate is included as a contra-account to accounts receivable on the balance sheet and is included as bad debt expense on the income statement when the estimate is made. | Management must exhaust every effort to collect on a receivable. If it is then determined that a receivable cannot be collected management will use the direct write off method to reduce accounts receivable by the uncollectible amount and include bad debt expense on the income statement for the uncollectible amount. |
| Business Alternative Income Tax Expense | The tax is calculated based on actual income at year end. If there is a difference between the year-end calculation and the amount the entity paid during the year, an asset or liability is recorded to reflect the actual tax expense based on income | The tax that has been paid by the entity during the year is the expense that is included in the income statement. There is no adjustment for actual results at year end. |
| Depreciation | GAAP requires fixed assets to be depreciated using the straight-line method of depreciation over the estimated useful life of the asset
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The internal revenue code allows for various accelerated methods of depreciation and provides the asset class lives that must be used. Depreciation expense under the income tax basis of accounting will generally be higher during the earlier years a fixed asset is placed into service.
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| Like-kind exchange | Property acquired pursuant to a like‐kind exchange is recorded at fair value on the date of acquisition. | Property acquired pursuant to a like‐kind exchange is recorded at the tax basis of property relinquished, increased by gain, if any, recognized on the exchange. |
| Deferred mortgage costs | Deferred mortgage costs are shown net of the liability associated with the cost, and amortization of debt issuance costs are included as interest expense on the income statement. | Deferred mortgage costs are shown as an asset on the balance sheet. Amortization of debt issuance costs is recorded on the income statement as an amortization expense. |
Before entering into a financial agreement with a municipality in connection with a PILOT program or any other agreement that requires the submission of financial statements it is important that you understand the method of accounting that you will be required to adhere to. These agreements often include financial covenants that need to be met to maintain the agreement or avoid paying additional fees or penalties. Without a solid understanding of the method of accounting required it is impossible to know if you can meet those financial covenants.
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