Accounting for House Flippers: Best Practices Investors Should Know
If you are a flipper or want to be a flipper, you need to think about implementing sustainable and scalable systems in order to automate your business and grow. A successful flipping business is made up systematic processes that allow for streamlining deal flow. On the back end, an important system in a flipping business is that of accounting.
Accounting for expenses will be vital to the success of your business. Not only will accurate reporting decrease your overall taxable profit, but it will also prove to future potential investors and lenders that you are running your business professionally. While you can hire out the accounting role, it’s difficult to hire out expense tracking, specifically logging receipts from your various expenses.
Developing a good accounting/expense tracking system isn’t as difficult as it sounds. There are software programs and apps galore that aim to help you keep organized. I’m going to give you a few tips as to how you can stay organized and what you will need to show your accountant at year-end. Ultimately, though, remember that a “system” is supposed to help you streamline your business. It should be so easy to run that you can delegate it to a competent employee with minimal instruction, and they can run it without error. Keep that in mind as you develop any system for your business.
Developing a Sustainable Accounting System
The first question we want to ask in developing an accounting system for flippers is: how do we want to keep track of and book revenues and expenses?
To keep track of revenues and expenses, we need to develop an easy and repeatable method to record receipts and invoices. This can be the basic “shoebox” method (not recommended), where you simply store receipts in a shoebox or file folder and hand it off to your accountant at year end. Though this method will cost you more money at year end due to more use of the accountant’s time, it is an easy and repeatable system.
A better method of revenue and expense tracking will be to utilize software programs and apps. A great app for expense tracking is Expensify (no affiliation). The app allows you to scan a receipt, enter the amount, categorize it, and store it in the cloud. This is the shoebox method on steroids, and it’s easier to maintain. You should also be using mileage apps (or a notebook) to track mileage while you are on the job. For 2015, every mile you drive will constitute a $0.575 deduction using the standard method. If you want to read more on the deductibility of travel expenses, check out this article I wrote.
You can also consider using accounting software, such as Quickbooks. I use Quickbooks Online with most of my clients, and they love it because all they have to do is link their bank and credit card accounts and write a short memo on each receipt until I can establish a pattern. Once I establish a recognizable pattern, my clients don’t even have to worry about their books unless I have a question about a transaction. Talk about automation.
Regardless of what method and software/app you utilize, you should use basic categories for your transactions. These categories will typically consist of:
- Acquisition costs
- Rehab costs (improvements)
- Repair costs
- Holding costs
- Selling price
- Selling costs
I list both rehab and repair costs because the IRS treats the two expenses very differently. Usually, this breakout won’t matter for a flip; however, what happens if your flip doesn’t sell? What happens if you need to rent it instead? This is when differentiating these two categories will start to matter.
The key is to keep it simple. Remember, we want an easy and repeatable system – one that we can hand off to an employee with minimal instruction, and they can execute without error. Don’t get too caught up in the expense categories, and if you have a question about a transaction, ask your CPA.
What Types of Supporting Records Should You Keep?
Except in a few cases, the law does not require any specific kind of records. You can choose any recordkeeping system suited to your business that clearly shows your income and expenses. As I mentioned above, you can utilize the shoebox method; however, I’d recommend going with a software program and using apps to help streamline your bookkeeping.
In terms of supporting documentation for the property purchase and sale, we will want to keep all applicable HUD-1 statements and any receipt in relation to the purchase or sale of the property. We will also want to keep the property’s tax assessment card (from the county), as well as an appraisal and insurance documents when applicable.
Expenses that you incur as part of the rehab or holding costs will also need to have supporting documentation. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following:
- Canceled checks
- Cash register tapes
- Account statements
- Credit card sales slips
- Petty cash slips for small cash payments
You may also need to issue informational returns on occasion. These returns will consist of Form 1099-MISC and Form W-2.
If you make or receive payments in your business, you may have to report them to the IRS on informational returns. The IRS will compare the payments shown on the informational returns with what is reported on the person’s returns who received the income to ensure they actually report the income earned. Failure to file informational returns results in failure to file penalties, which can become quite pricey, so make sure you understand the following section.
You will need to file Form 1099-MISC, Miscellaneous Income, to report certain payments you make in your trade or business. Straight from Publication 583, these payments include the following:
- Payments of $600 or more for services performed for your business by people not treated as your employees, such as subcontractors, attorneys, accountants or directors
- Rent payments of $600 or more, other than rents paid to real estate agents
- Prizes and awards of $600 or more that are not for services, such as winnings on TV or radio shows
- Royalty payments of $10 or more
- Payments to certain crew members by operators of fishing boats
You will file Form W-2, Wage and Tax Statement, to report payments to your employees, such as wages, tips, and other compensation, withheld income, social security and Medicare taxes. If you have W-2 employees, it’s highly recommended that you utilize a software program with an integrated payroll service to make your books that much smoother.
Cash vs. Accrual Method of Accounting
When you are running a business, you need to decide which method of accounting you will utilize for your business: the cash or accrual method.
Most taxpayers use the cash method of accounting for their personal returns. The cash method basically says that income is recognized when the check is received and expenses are recognized when paid. So on December 31st, 2015, if a tenant pays you 12 months of rent for 2016, all of that income will be recognized in 2015 based on the cash method of accounting.
The accrual method of accounting recognizes income and expenses when they are earned or incurred, not when you receive the check or pay the expense. Continuing the example above, if the tenant pays you 12 months’ rent on December 31st, you do not recognize any of that income in 2015 because it all applies to 2016. Insurance is another great example – even though you may pay an upfront lump sum payment, you recognize the expense on your books every month as the actual expense is incurred. Specifically, the prepayment will be in an account called “prepaid insurance,” which will be reduced each month by “insurance expense.” This is the accrual method of accounting.
Have I lost you yet? Let’s see how this applies to flippers.
If you plan on (or already are) flipping multiple properties, the IRS will likely classify you as a dealer. For accounting purposes, this means that your houses will be classified as inventory, and the IRS will require you to use the accrual method of accounting. For this reason, I recommend that you go ahead and use the accrual method of accounting from day one; this way, you don’t have to pay an accountant costly fees to transition your books to the accrual method later on.
I hope this information helps you develop a good accounting system. If you are just starting out, strive to keep it simple. As you grow, look into software programs that best fit your needs in order to streamline your accounting and recordkeeping functions. After all, you want to be out in your market closing deals, not spending your time performing back office accounting functions.