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GAAP vs. Income Tax Basis Accounting

Meyer Mintz, CPA, J.D., LL.M. and Marc Fogel, CPA
04.05.2017 | Berdon Industry Insights

Owners, investors, and operators of real estate assets have increasingly turned to the use of income tax basis financial statements. The rise in the use and acceptance of income tax basis statements represents a departure from the historical use of Generally Accepted Accounting Principles (GAAP) statements, which continue to become increasingly complex and, in some instances, simply not as relevant to the real estate world.

Here’s the simple truth: GAAP remains the most common reporting standard for financial statements in the U.S. That means that the boilerplate language often used in loan covenants calls for the preparation of GAAP financial statements.  Also, other documents such as leases and management agreements often call for calculations to be done based on “income” or Net Operating Income (NOI) and can use GAAP as a reference point. In addition, income tax basis reporting is required for the preparation of income tax returns. This reality also makes the GAAP report superfluous for income tax planning. So twice the work is done and additional monies can be spent in the compliance process.

But it doesn’t have to be that way.

Lenders are becoming increasingly receptive to the use of income tax statements. But, as the owner or operator, it is critical that you resolve this issue before entering into binding agreements, such as mortgages, leases, and related loan covenants. You should also review the situation with your certified public accountant to make sure that you understand the tax ramifications of whatever reporting method you choose.

There are some fundamental differences between the two reporting methods. In its simplest sense, GAAP reporting is designed to show earnings in the period earned rather than when cash is received or expended, which if often what lenders want to see (and owners want to show). They want the comfort of knowing that income from the building will comfortably exceed its debt service.

Conversely, when filing income tax returns, owners typically want to show as much loss as they can, using as many deductions as possible and deferring income to reduce taxable income and the taxes that will be due. The difference is most obvious in the treatment of depreciation: GAAP requires that fixed assets be capitalized and depreciated over their useful life, which might be decades. The income tax rules generally allow the use of asset lives and allowable methods that are set by the IRS and determined with the execution of a cost segregation study. These depreciation differences often produce the biggest dollar value adjustments when arriving at an entity’s taxable income. Also, the rules regarding what is a deductible “repair” are substantially more liberal for tax purposes, especially after adoption of the repair regulations.

Timing of income recognition can also be different – prepaid rent may be required to be recognized for income tax purposes but deferred for GAAP until the period it is due. Also, for GAAP purposes, any free rent period is amortized over the life of the lease – so even if there is no cash in the first year, because of this there will still be income. For tax, it is generally not recognized until it is due under the lease. This may make a difference when calculating certain debt covenants that reference income or NOI.

Then why choose GAAP? Why spend the time and money to produce a financial statement under GAAP principles? Public companies, including public REITs, and institutional Investors are often required to file using GAAP standards, so they may require their partners to report using GAAP as well. GAAP, because of its standard set of rules, is considered to be more uniform and comparable than that of income tax basis accounting.

If an institutional investor or fund is not involved in a transaction, most owners and operators of private companies will find the income tax basis reporting easier, and therefore more beneficial. If an institutional investor or fund is later involved in a transaction, you might then be required to go back and recreate GAAP financial statements for the building. This process could require going back to inception and recasting all prior years using GAAP, which can be a time consuming and expensive process, depending in part upon the age and original purchase date of the building.

Here is a short list of questions to consider prior to changing your method of financial reporting:

  • Do you intend to admit a new partner into the venture, and if so, when? If you anticipate a new partner in the near future, you should try to determine the reporting preferences and requirements of the potential partner.
  • Are there specific requirements in your loan covenants regarding financial statement preparation? Even if the answer to this question is yes, you can still approach your lender regarding a change.
  • Can you handle variations in income from year to year? The tax basis of accounting, which more closely resembles the cash basis of accounting, may create larger variations in income from year to year.

Even with these considerations, it cannot be repeated enough that no matter what method you use for financial statement or reporting purposes, look at the mortgage and other peripheral documents to make sure that other definitions such as cash flow and income are consistent with expectations. Just because the financial statements can be done using one method does not mean the mortgage won’t modify the method used for other purposes. Not realizing this may cause you to fail a covenant, which is never a good thing.

While it is advantageous to pay as little tax as possible, you cannot overlook the requirements of an existing, or perhaps potential, lender.

Questions? Contact your Berdon advisor or Meyer Mintz, CPA, J.D., LL.M. or Marc Fogel, CPA – Berdon LLP, New York Accountants.