How do I set up the Chart of Accounts for my rental property business?
Properly setting up the chart of accounts for your rental property business will save you time and help you get the most out of your accounting system. To do so, consider your goals first and then work backwards.
Most investors keep their books because 1) the government mandates an accurate reporting of income and expenses for tax filing and 2) they want to understand how their rental business is performing.
What does that mean for you in practice? First, your chart of accounts, at minimum, needs to include all of the categories that need to be reported on your tax forms (such as the IRS Schedule E). Second, you will need additional categories or subcategories for any items that you would like to track in more granular detail.
To fully explore this topic, we will take a quick step back to talk about what a chart of accounts is, examine real estate and rental specific considerations for each account type, and finally provide an example chart of accounts for a small to medium sized landlord.
What is a Chart of Accounts?
Fundamentally, a chart of accounts is just a list (“chart”) of all the different financial labels (“accounts”) that your business uses. You will use these accounts to track the money your business receives, spends, or stores by recording transactions. Think of the chart of accounts as your financial filing system. If you want to measure or categorize something, it needs to be in your chart of accounts.
Each account in the chart of accounts is assigned a type. There are five core types of accounts:
Revenues: Where your business earns money- rents, tenant fees, etc.
Expenses: Where you spend money operating the business- cleaning, property management fees, etc.
Assets: things you own, like bank accounts or properties
Liabilities: things you owe, like mortgages and credit cards
Equity: money that you’ve put in to the business or business earnings that you’ve reinvested
Accounts of any type can be broken down into sub-accounts. Using sub-accounts can help you view information in deeper detail, while still ensuring that all transactions funnel up to desired parent categories, like those required by tax forms.
Multiple properties and the Chart of Accounts
Real estate investing requires the ability to view the finances of all owned properties separately as well as on a portfolio level. This is both to understand the performance of individual properties and because the IRS mandates a property by property breakdown on the Schedule E form for passive rental income. This breakdown is NOT done through the chart of accounts.
Instead, robust accounting systems support the use of classes or tags. In REI Hub, owners can create properties, units, or even legal entities and tag them to transactions. These tags work in conjunction with the chart of accounts to segment financial reports and allow for reporting on only a subset of the business.
Creating a Chart of Accounts for a rental property business
Generic accounting software will include a default chart of accounts that is applicable to a broad variety of businesses. Since REI Hub was designed specifically for real estate investors, we use the IRS Schedule E form filed by most rental property owners as our starting point when creating our chart of accounts. In this example we’ll do the same. (Want accounting software ready for rentals? Click to learn more about REI Hub.)
Completing the Schedule E requires revenue and expense information for the tax year on a property by property basis. Reporting balance sheet accounts (assets, liabilities, and equity) is not required annually; however, adding them is important. Some of them are payment accounts which allow you to track the flow of funds throughout your business. Others hold the information you need to calculate your annual depreciation expense, view loan paydowns, or properly dispose of the property.
Revenue Accounts
The Schedule E contains only one commonly used revenue account - rents received. Revenue generated from other rental activities should also be reported under this category, making it a great candidate for sub-accounts. Frequent sub-accounts include application fees, security deposits withheld, pet rent, passthrough utility payments, and more depending on your business’s circumstances and needs.
Expense Accounts
There are 15 expense accounts included on Schedule E that encompass many common investment property expenses, such as repairs, insurance, mortgage interest, and more. Each covers a broad swath - if you want more detail as to where your money is going, you can use subaccounts (roof repairs, HVAC repairs, interior repairs, etc) to further segment your reporting while still keeping to the required buckets. For anything that doesn’t quite fit, “Other Expense” is also a standard category, although you may need to provide additional information at tax time about any transactions categorized there.
Asset Accounts
Most rental property owners have one or more business bank accounts (Read our blog on why you need a separate business bank account for your rentals). Each account should be included as an asset in the chart of accounts so that revenues received or expenses paid by these accounts can be properly recorded on transactions. Mortgage escrow accounts are also asset accounts if they are applicable to your business and financing.
If you use a property management company, you should create an asset account for your property manager (note: property management asset accounts are in addition to the standard expense account “Management Fees”). They are likely accepting rent and incurring expenses on your behalf. Creating an asset account allows you to select the management company as a payment source or deposit destination, allowing you to quickly compare their statement with your books, record transfers from or to your property manager, or segment your out-of-pocket expenses versus those incurred by the manager on your behalf.
Other standard asset accounts for your rental property business include land, buildings, and improvements. When you purchase a property, the price and any non-deductible closing costs are prorated between the land and buildings accounts. Any capitalized improvements that you have made are added to the improvements account.
Depreciation expenses are recorded annually for buildings and improvements. A special account called Accumulated Depreciation is used to track depreciation over time, allowing you to view the original asset values, accumulated depreciation, and the net asset value remaining on the balance sheet.
Liability Accounts
Several common financial accounts should be created as liabilities in the chart of accounts. Mortgages, home equity lines of credit, and credit cards are all liabilities.
The other common liability account for rental property businesses is Security Deposits Held. When you receive a security deposit, this liability increases. The funds go onto your books earmarked for return to your tenants, and in many states you are legally prohibited from co-mingling them with operating funds. When you return a security deposit, the liability reduces, as it does when you retain a deposit and record revenue.
Equity Accounts
Equity accounts on the chart of accounts include owner contributions and distributions. These track the money that you put into or take out of the business. Any expenses paid via cash or from an account not included on the chart of accounts should be classified as an owner contribution.
Retained earning and net income are both accounts displayed on the balance sheet, but are derived from your income statement rather than listed directly on the chart of accounts. Retained earnings refers to the cumulative income or loss by the business that has not been distributed to owners. Customarily, this account is split in two with net income representing income or loss from the current accounting period and retained earnings being the sum of prior accounting periods.
For already operating businesses implementing a more rigorous accounting system - an Auto-Balance equity account can make it easier to enter starting bank balances, record past capital improvements, enter prior year income, etc if detailed records do not exist to enter or summarize all past transactions.
Conclusion
Setting up the chart of accounts for your rental business is an important precursor to efficient and accurate bookkeeping. Although the basic account types included in the chart of accounts are constant, accounting practices allow great flexibility in the number and detail of accounts listed. Many real estate investors are well served by starting with their tax reporting requirements and expanding into more detail where desired. Thanks for reading!
