Rental Property Accounting Methods

As a landlord, there’s no universally perfect way to handle your rental income accounting. In 2021, there were around 9.635 million landlords in the United States—yet it’s likely that none of them handled their accounting for rental properties the exact same way.

There are two main methods of income and expense tracking for your rental property accounting: cash basis and accrual basis. It’s important to know the basic rental income accounting methods so that you can determine what works best for you.

Cash vs. Accrual Accounting

The most common methods of accounting are cash and accrual accounting. Below, we’ll explore what each of these are, as well as when real estate investors may want to use each, their benefits, and some drawbacks.

Cash Accounting

The cash basis accounting method is, as the name implies, more focused on the actual money that you have at a given time. It prioritizes the tracking of transactions right when they happen—when the money enters or exits your bank account.

Let’s say you have a tenant who pays you five days after rent is due on the 1st of the month. With cash basis accounting for rental income, you would record that money on the day that you actually received it, not the day that you were expected to receive it. In this scenario, you would record your tenant’s rent payment on the 5th, not the 1st. With the cash method, you know exactly how much cash you have in your account at any given time.

An important tax principle applies when using cash basis accounting for rental income: the constructive receipt of income principle. This principle holds that you must track income the month that it is credited or available to you even if you do not technically have the cash in hand yet. If you receive rent in the form of a check at the end of the month but do not cash it in until the next month, you track it as income for the month that you received the check itself in. This rule was established to generally keep taxpayers from neglecting their tax obligations by purposefully waiting to cash in checks and the like.

Additionally, the cash basis method of rental accounting can simplify your income taxes, as you are strictly tracking the income that you receive in a fiscal year, and not what you should have received. You won’t have to worry about accidentally recording any rental property income that you never received (defaulted rent, etc.), as you only track it when you receive it.

Benefits

• Keeps you aware of the money you currently have
• Often useful for smaller businesses
• Generally simpler than accrual basis accounting

Drawbacks

• Not always an accurate depiction of your financial health (Will reflect poorly on your finances if a tenant pays rent late, etc.)
• Focuses only on cash flow (rental expenses and income) and not on other data points

Accrual Accounting

Accrual basis accounting, on the other hand, operates a little differently. It tracks payments as they are earned or incurred (expected to be received) rather than when they are actually received.

Using the same scenario from earlier, if a tenant pays rent five days late, you would still track the income on the 1st when it was due, not on the 5th when it was received, because the money was still owed to you on that date. With this method, landlords typically use the current status of invoices and bills to track their transactions. It’s more commonly used by landlords with more complex finances, as it helps to keep track of whether payments have been received or not. This essentially makes it easier to see what you’re owed and by whom if you did not receive it when you were supposed to.

Likewise, if you’ve paid or plan to pay an expense but the funds have not been transferred yet, your finances accurately reflect that you no longer “have” that money. If you write a check for a service and the recipient doesn’t cash it for a month, your books will already have reflected that expense in preparation for paying it.

When using the accrual method, you generally deduct rental property expenses in the year that you incur them, even if the money hasn’t left your account yet. But depending on your situation and your wants, you can choose to either send bills early or hold off on sending them so that they can count for one fiscal year or the next.

Benefits

• Considered a more accurate depiction of cash flow over time
• Often useful for larger businesses with more moving parts
• Helps track unfulfilled obligations and expenses

Drawbacks

• Doesn’t always reflect the money you have at a given moment
• Can be difficult to learn

Hybrid Accounting

A much less common approach to property rental accounting, hybrid accounting, works as a combination of both cash and accrual methods. With this method, you can choose to track transactions in a more flexible way.

If a business wants to prioritize certain goals, then hybrid accounting allows them to utilize aspects of both cash and accrual methods. There are a few restrictions when it comes to when you can and can’t use hybrid accounting as a business, so be sure to do more research or to contact an accounting professional for more advice.

For example, if a business such as a supermarket or restaurant that sells goods were to rely on an inventory to account for their income, they’d be required to use an accrual basis accounting method for their bookkeeping. Therefore, it’s important that you don’t start tracking your rental income and expenses however you want, as there are IRS procedures to govern this hybrid process.

What’s Best for Your Business?

Deciding which method is best is typically done on a case-by-case basis. Only by assessing your rental property business and the intricacies of its transactions can you find the best answer for your situation. There are, however, a few rules and indicators:

1. Businesses with an average of $25 million or more in annual sales for the last three years must use accrual accounting per the IRS.
2. Cash accounting is typically preferred by smaller business owners because of its simplicity. When working with smaller expenses and profits, it’s beneficial to know exactly how much is in your account.
3. Accrual accounting is typically preferred by businesses with more complex accounting, more employees, etc. If you manage a large number of units and money is constantly flowing, it may be beneficial to use the accrual method.
4. If you’re looking to attract lenders and investors, accrual accounting will offer a more accurate snapshot of your profitability and expected income than cash accounting will.

Regardless of what you land on, consistency is key! Pick an accounting method and stick to it in order to avoid audits and other legal issues. If the IRS has any reason to suspect that your methods of tracking are sporadically changing, they will likely investigate.

Conclusion

The world of rental income accounting is your oyster! Now that you better understand cash vs. accrual accounting, it’s time for you to choose what method is best for your rental property business. Each method has its own benefits and drawbacks, so it’s in your best interest to do some extra research as needed and/or to speak with a professional if you’re still unsure.