There are some common types of costs incurred in an
operating property are: Cleaning services; Security; Water; Electricity;
Heating-ventilation-and-air-conditioning (HVAC); Payroll; Insurance; Repairs
and maintenance; Leasing costs; Loan closing costs; Management fees; Property
taxes; Sales and use taxes; Additional services bill-backs.
1. Cleaning Expenses
Cleaning involves the cost of cleaning both inside and
outside of the property. This service is either provided by the property
owner’s personnel or outsourced to third-party cleaning companies. If it is
performed by the owner’s personnel, this cost would be part of payroll
expenses. Cleaning cost is a period cost and should be expensed during the
applicable periods.
Therefore, the journal entry to record this type of expense
would be:
[Debit] Cleaning expense = $xx
[Credit]. Cash or Accounts Payable = $xx
However, in an outsourced cleaning scenario, the parties
might agree that the owner would pay in advance every six months. In this case,
the amount paid in advance would be a prepaid asset and amortized over the
beneficial period. Assume the landlord paid $120,000 for cleaning service for
the period January 1, 2009 to June 30, 2009, and this amount was paid on
January 1, 2009.
The initial and monthly entries would be:
(a). January 1, 2009:
[Debit]. Prepaid cleaning expenses = $120,000
[Credit]. Cash = $120,000
(To record prepaid cleaning for period January 1, 2009 to
June 30, 2009)
(b). Monthly starting January 1, 2009:
[Debit]. Cleaning Expense = $20,000
[Credit]. Prepaid assets—cleaning = $20,000
(To record monthly clean expense [120,000/6 = $20,000])
2. Security Expenses
Security expenses are payments to security companies for
providing their security personnel to the property. The services provided by
these personnel could include registering guests entering the building,
confirming guest visits with the hosting tenant, issuing security passes (IDs)
to tenants, surveillance of the exterior and hallways of the building, and a
host of other responsibilities.
The fees paid for these services are expensed during the
applicable periods similar to the cleaning service discussed earlier.
The joined entry recorded for the charge is:
[Debit]. Security services expense = $xx
[Credit]. Cash or Accounts Payable = $xx
3. Water, Electricity, HVAC
(Heating-Ventilation-Air-Conditioning) Expenses
Water, electricity, and HVAC
(Heating-Ventilation-Air-Conditioning) represent major expense lines in an
operating property income statement. The charges for these items are billed by
the utility provider to the property.
In some cases, where there are sub-metering arrangements,
these charges can be billed directly to tenants. Sub-metering prevents the
allocation of these costs by the landlord using tenants’ pro rata shares of the
building. Instead, meters are installed for every tenant in the building.
The entries to record these types of charges are:
[Debit]. Water expense = $xx
[Debit]. Electricity expense = $xx
[Debit]. HVAC expense = $xx
[Credit]. Acquired expense $xx
Note: The “Acquired expense” account, later, will be
reversed with “cash” when tenants’ pro rata shares have been properly
determined and payment to the utilities’ provider have actually been made.
4. Payroll Expense
Payroll includes the compensation cost of all the personnel
who perform work for the property. It also includes all employees’ employment
benefits. Some personnel commonly found at the property include the property
managers, engineers, accountants, administrative assistants, and bookkeepers.
All compensation to these individuals is recorded as payroll expense.
The entry to record payroll expenses is:
[Debit]. Payroll expense = $xx
[Credit]. Cash or Accounts Payable = $xx
5. Insurance Expense
The insurance category represents the cost of purchasing
insurance coverage for the property. The amount paid to the insurance company
is called the insurance premium. Depending on the insurance company and the
arrangement with the property owner, the insurance premiums can be due monthly,
quarterly, or annually. Premiums usually are paid in advance.
When premiums are paid in advance, they should be recorded
as a prepaid expense and amortized over the coverage period.
Assume the property owner paid $30,000 on January 1, 2009
for insurance coverage for the period starting on January 1, 2009 and ending on
June 30, 2009.
The entry to be recorded on January 1, 2009 when the amount
was paid would be:
[Debit]. Prepaid insurance = $30,000
[Credit]. Cash = $30,000
Therefore, at the end of each month, an entry would need to
be recorded to recognize the insurance expense. This entry would be:
[Debit]. Insurance expense = $5,000
[Credit]. Prepaid insurance = $5,000
At the end of the first month, the balance of prepaid
insurance would be $25,000 [=$30,000 – $5,000].
6. Repairs and Maintenance Expense
Repairs and Maintenance are costs spent to keep the property
for its intended use. Examples include repair of broken windows and doors,
repair of toilets stoppage, replacement of light bulbs, maintenance of the
heating system and air conditioner, maintenance of elevators, and so on.
Numerous bills fall into this type of expense. Repairs and Maintenance expenses
are period costs and should be expensed as incurred.
The entry to record the cost is:
[Debit]. Repairs and Maintenance expenses = $xx
[Credit]. Cash or Accounts Payable = $xx
7. Leasing Costs
Leasing costs are the costs incurred to lease the premises
to tenants. The most common leasing costs are broker’s commissions and legal
fees. Broker’s commissions are paid to brokers for securing a tenant who leases
the premises:
In a residential lease, the commission is typically paid at
lease signing and the payment obligation varies between the landlord and the
tenant.
In commercial leases, the broker’s commission payments are
typically spread over the length of the lease and are specified in the commission
agreement between the leasing broker and the landlord.
The most common commission agreement entitles the broker to
a portion of the commission upon a tenant’s signing of the lease; the remainder
is paid over the term of the lease. Sometimes the landlord and broker may agree
that the broker is entitled to an additional commission if the tenant renews at
the end of the original lease.
The accounting journal entry to record broker’s commission
is different from how some of the other costs described above are recorded. The
total commission is recorded as a prepaid expense and amortized over the length
of the lease.
Case Example
Assume the broker and landlord agree that the total broker’s
commission for a 5-year lease with a commencement date of January 1, 2009 and
expiration date of December 31, 2013 is $600,000, of which $300,000 is paid
upon lease signing with the remaining $300,000 paid on January 1, 2011. Assume
the lease was signed on November 15, 2008.
The entry to be recorded upon signing the lease and payment
of $300,000 to the broker would be:
[Debit]. Prepaid broker’s commission = $600,000
[Debit]. Accrued broker’s commission = $300,000
[Credit]. Cash = $300,000
Thereafter, during the lease period (January 1,
2009–December 31, 2013), the monthly entry to record the amortization of the
prepaid broker’s commission would be:
Total
commission =
$600,000
Number of
months :
60
Monthly amortization = $
10,000
Therefore, the journal entry is:
[Debit]. Amortization expense:
broker’s
commission
= $10,000
[Credit]. Accumulated amortization:
broker’s
commission
= $10,000
Then at January 1, 2011, when the remainder of the broker’s
commission is paid, the entry would be:
[Debit]. Accrued broker’s commission = $300,000
[Credit]. Cash = $300,000
Legal fees are the fees paid to an attorney for drafting the
tenant lease agreement. In most leases the legal fees are paid upon signing the
lease. Regardless of when they are due or paid, the amount should be
capitalized and amortized over the term of the lease.
Case Example
Assume that for the same lease transaction just discussed,
the landlord paid $60,000 in legal fees. The entry required upon signing the
lease would be:
[Debit]. Prepaid legal fees = $60,000
[Credit]. Accrued legal fees = $60,000
When the legal fees are paid, the required journal entry
would be:
[Debit]. Accrued legal fees = $60,000
[Credit]. Cash = $60,000
Each month during the lease term, the amount of legal fees
to be expensed is calculated as:
Total legal
fees = $60,000
Number of months
: 60
Monthly expense =
$ 1,000
And, the journal entry is:
[Debit]. Amortization expense—legal fees = $1,000
[Credit]. Prepaid legal fees = $1,000
8. Loan Closing Costs
In a real practice, the purchase of real estate in most
developed economies is mostly financed with debt. Debt financing involves costs
such as application fees, origination fees, administration fees, and
syndication costs, among others. These costs are called “Loan Closing Costs”.
These costs should be capitalized and amortized over the
life of the loan. Assume debt was used to finance a real estate asset purchase
and the total loan closing costs were $500,000 on a 10-year debt financing.
The entry to record the loan closing costs is:
[Debit]. Loan closing costs (assets) = $500,000
[Credit]. Cash = $500,000
The monthly amortization of this cost during the loan period
would be:
Total loan closing costs = $500,000
Loan period in months
: 120
Monthly amortization = $4,166.67
The monthly journal entry would be:
[Debit]. Amortization expense—loan
closing
cost
= $4,166.67
[Credit]. Accumulated amortization—loan
closing
cost
= $4,166.67
9. Management Fee
In some cases the owner of a real estate entity hires a
professional real estate management firm to manage the property. These firms
provide the staffing, interface with the tenants, lease vacant space, procure
supplies, and collect rents, among other responsibilities.
Management fees are recorded as assets when paid and
amortized over the engagement management period unless the amounts are paid
periodically over the management period.
10. Property Taxes
Generally property taxes are billed by the city or
municipality where the property is located. Property tax is a major source of
revenue to local governments and a major expense line on a property’s income
statement. The amount of taxes paid on a property is assessed by the government
taxing agency. The importance of this cost is very evident upon review of a
property’s financial statement. It is usually one of the largest costs of
operating a property.
Most taxing authorities give property owners the right to
challenge the assessment value used in determining the property taxes.
Attorneys and other professionals specialize in helping
owners to obtain a fair assessment of their property and thereby reduce their
property taxes. Most of these professionals are paid on a contingency basis
based on the successful reduction of the taxes. In some cases, their fees can
be up to 30 percent of the annual tax reduction. This can be a very profitable
profession, especially in cities where property taxes on commercial properties
are in the millions a year.
Property tax billing varies between cities. Some cities bill
monthly or quarterly while some others bill semiannually or annually. However,
regardless of how often the property taxes are paid by the owner, the cost
should be expensed over the applicable tax period.
For some municipalities, property taxes are paid in advance;
for others, they are paid in arrears.
The bill should be thoroughly reviewed to ensure that the
amounts are expensed during the correct period. Assume that a municipality
bills property taxes in advance semiannually. In this case, the payment by the
property should be recorded as prepaid property taxes when paid and expensed
pro rata over the six months.
Property Tax Case Example
If on January 1, 2009 the property owner paid $600,000 for
property taxes for the period January 1, 2009 through June 30, 2009, the
initial and subsequent monthly journal entries would be:
(a). On January 1, 2009:
[Debit]. Prepaid property taxes = $600,000
[Credit]. Cash = $600,000
(To record property taxes paid for period January 1, 2009
through June 30, 2009)
(b). Monthly starting January 1, 2009:
[Debit]. Property tax expense = $100,000
[Credit]. Prepaid property taxes = $100,000
(To recognize property tax expense for the month)
(c). At the end of the first month, the prepaid taxes
balance would be:
Original prepaid property
taxes
= $600,000
Property taxes expense in January 2009
(-)$100,000
Prepaid taxes balance at January 31, 2009 = $500,000
Assume instead of in advance, property taxes for the period
of January 1, 2009 through June 30, 2009 are due and paid on June 30, 2009. In
this case the property owner would still have to recognize property tax expense
each month by recording an accrual each month. The required monthly journal
entries would be:
(a). Monthly journal entries starting January 31, 2009:
[Debit]. Property tax expense = $100,000
[Credit]. Accrued property taxes = $100,000
(To accrue monthly property taxes due June 30, 2009)
(b). Journal entry on June 30, 2009:
[Debit]. Accrued property taxes = $600,000
[Credit]. Cash = $600,000
(To record payment for property taxes for January 1, 2009
through June 30, 2009 due on June 30, 2009)
These entries ensure that the property’s financial statement
appropriately reflects the property tax expenses every reporting period.
11. Sales and Use Taxes
Sales tax is a state tax on the retail sale of tangible
personal property or services. Sale taxes are normally collected by the seller
from the purchaser on behalf of the state. The seller in this capacity acts as
the custodian for the state in collecting these taxes. Use tax is a government
tax on the use or consumption of tangible personal property or for services
where sales tax was not charged by the seller at the time of the transaction.
Generally, goods used in a manufacturing capacity are tax exempt because they
are part of inventory.
Use taxes arise because sometimes, during the purchase, the
purchaser has not decided whether the goods would be consumed by the purchaser
or used in the production of a final product. If the purchaser ends up using or
consuming the goods, the purchaser has to pay use tax to the state.
A purchaser is subject to sales or use tax on tangible
personal property if three conditions are met:
There is transfer of title or possession.
There is transfer of the right to use or control.
There is transfer of consideration such as credit, money, or
extinguishment of debt.
Note: Sales and use taxes are not required on intangible
personal property; however, services are subject to sales and use taxes. Care
should be taken to differentiate between intangible personal properties and
services.
Certain purchasers and products are exempt from sales and
use taxes. Examples of exempt purchasers include government agencies, religious
organizations and societies, educational organizations, and charitable
organizations.
Some products exempt from these taxes include donations to
nonprofit organizations, publications, research and development, and tangible
goods used in the manufacturing, processing, or production of inventory for
sale. It is also important to note that different states have different rules
on exempt purchasers and products.
Rental income is also exempt from sales or use tax.
Landlords’ charges for overtime freight elevator service, overtime cleaning,
heating, air conditioning services, and electricity are also exempt from sales
or use tax because tax rules consider them as incidental to the rental of the
premises.
12. Additional Services Bill-backs
In some cases tenants may require additional services above
and beyond the normal level of service agreed to on a lease. These may include
requests for HVAC after normal work hours, additional security, or cleaning
during certain events. These types of costs are billed back to the requesting
tenant and not included as part of operating expenses billed to all tenants.
These additional costs are recorded differently depending on
whether the books and records of the property are kept on a GAAP or federal tax
basis:
On a GAAP basis, the additional billing to the tenant is
included as revenue with the corresponding cost recorded as expense.
On a federal tax basis, this additional billing is not
reported as revenue unless there is a profit earned on this transaction by the
property, which would then be reported as revenue.
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