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Organizing Your Records

If you have an aversion to details and keeping track of things, managing your own investment rental properties may not be for you. If you own rental property, you need to prepare many important written records and keep them ready for prompt retrieval. Scanning and storing documents electronically is easier today than ever, so you may opt to keep many of these files and copies of all important documents on your computer.

Keeping records up-to-date and accurate

Maintaining complete and accurate records of all transactions is extremely important in the world of property management. Having your records squared away is necessary on four fronts:

Taxation: You have to report your income and expenses for each rental property on IRS Form 1040 Schedule E to determine your taxable profit (or loss). The IRS requires rental property owners to substantiate all income and expenses by maintaining proper records, including detailed receipts of all transactions to support the accuracy of your tax returns.
Financial management: If you don’t accurately document all the income streams coming in and the expense payments going out, you won’t be a real estate investor for long. Check out the “Knowing What to Account For” section later in the chapter for tips and information on this key aspect of your rental property. Financial management is also an excellent barometer on the success of your rental property toward providing you with cash flow, equity build-up, and appreciation.
Litigation: Courts typically take the stance that residential tenants (and even small commercial tenants) are merely consumers, so the burden is primarily on the owner to provide any documents outlining the relationship or understanding between the parties. If the owner can’t provide the required records, the tenant almost always prevails.
Future refinancing or sale: Having accurate and detailed accounting records is important when you look to refinance or sell your property because the amount you can borrow or the sales price you can achieve will likely be based on the Net Operating Income (NOI) that you report. Both a future lender and a buyer will look for stable and predictable income as well as reasonable operating and capital expenses that support the fact that you competently managed, operated, and maintained the property.

Here are a few documentation tips (check out the “Filing made easy” section later in the chapter for ideas on how to store this info):

Document your income on income journals: Income journals are also called cash receipt journals and consist of the master rental income data collection sheet and ledgers for each individual rental unit or suite.
Keep all bank deposit slips: Although your bank may or may not require a deposit slip with your transaction, make a listing of all items deposited to keep for your records in case there’s a discrepancy between your recordkeeping and the bank’s records.
Get a written receipt for all expenses: Rental property expenses, even if you write a business check or make an electronic payment, must have a written receipt to fully document the expenditure. The IRS may not accept a check as proof of a deductible property expense unless you have a detailed receipt as well. Many home improvement suppliers and vendors now provide detailed receipts with specific descriptions of the purchased items, making this much easier than in the past.
If you have multiple rental properties, develop and assign a one- or two-character code for each property and mark each receipt accordingly. (Indicate the unit or suite number, if appropriate.) When you have information for multiple properties on a single receipt, make photocopies and store the receipts in the folders you’ve set up for your respective properties. This way, you can provide evidence of the expense for each property instead of having to wade through all your folders looking for the information you need.

If you use your vehicle for your rental property activities, be sure to keep a detailed written log of all your mileage. Your mileage is a deductible business expense as long as it’s directly related to your rental property and you have accurate records to document the mileage. Some apps are available that record business expenses. Regardless of your system, make sure that this simple log indicates the date, destination, purpose, and total number of miles traveled. You may be surprised at the number of miles you travel each year for your rental activities — the deductible expense can be substantial.

Here’s a general guide of how long to retain your records:

Keep all records pertaining to your rental property for a minimum of three to five years. (For property managers managing properties for others, the time period depends on the legal requirements of the state regulatory commission or department of real estate where the property is located.)
For tax purposes, records regarding the purchase and capital improvements made during your ownership need to be maintained for as long as you own the property.
Certain property records such as those concerning injuries to minors should be maintained essentially forever. Although even the IRS has a statute of limitations (except in the case of fraud), the statute of limitations for injuries to minors typically doesn’t begin to run until the minor reaches the age of majority (usually 18).

Filing made easy

Every rental property owner should have a basic filing system with separate records kept for each rental property. You may opt to keep many of the accounting records and files on your computer, including the recent ability to scan and store most documents, but for owners of one to several rental units, a manual system works just fine. Your filing system can be a simple accordion filing box with dividers, which you can find at any office supply store. If you own more properties and outgrow the accordion filing box, use a lockable fireproof filing cabinet.

Organize your records at the property level and the unit level. You’ll have some documentation overlap, but the benefit of having complete, easily retrievable records at your fingertips greatly outweighs the effort involved in making some photocopies. Start at the property level, and construct the following:

Ownership file: From the moment you take your first steps toward purchasing an investment property, begin storing hard copies of your paperwork in a property ownership file. Keep all the important documents of this transaction, including purchase offers and contracts, the closing statement, appraisals, loan documents, insurance policies, due diligence inspection and pest control reports, and correspondence. You may be tempted to go paperless by scanning and storing everything electronically, but these documents are critical, and you must always keep hard copies because electronic files can be lost. Also keep a photocopy of your deed in the property file, and place the original in a fireproof safe or bank safety-deposit box.
Income and expense files: Each of your rental properties should have its own file section with separate folders for income reports like rent rolls, as well as a separate folder for each of the major property expense categories. Keep copies of all receipts in the expense folders, so that when tax time rolls around, you can easily locate the information you need. Start a new file for each tax year.
Master maintenance file: We recommend keeping a master property maintenance file for the records and receipts for all maintenance and capital improvements for each rental unit or suite and the common areas. This one-stop source gives you the records you need for all repairs and maintenance during your ownership and can be helpful for your accountant in calculating your basis in the property when you ultimately sell or exchange the property.

Moving on to the unit level, put these files together:

Tenant file: Create a separate file for each tenant that contains all the important documents for each tenant, including her rental application, lease agreement, the tenant ledger showing all charges and payments, all legal notices, tenant maintenance requests, and correspondence. Although you can scan and store backup copies of these documents, always keep the original of each document and provide the tenant with a photocopy. You’ll need the signed originals of all pertinent documents should legal action ever become necessary. Individual tenant files are closed out and a new tenant file established upon turnover of a rental unit to a new tenant.
When your tenants vacate, attach a copy of any paperwork from the termination of their tenancy and bind the entire tenant file together. Transfer it to a separate file for all former tenants, filed alphabetically by rental property.
Unit maintenance file: We recommend keeping a separate maintenance file for each individual rental unit or suite with the records and receipts for all maintenance and capital improvements. This system gives you a history of the physical condition of each rental unit or suite throughout your ownership. This file remains open even when the tenants change.

Use a system for recording all significant tenant complaints and maintenance requests. This will provide a valuable paper trail if a dispute ever arises regarding your conduct as an owner in properly maintaining the premises. Failing to have good records may well hurt your case should a dispute escalate and end up in court.

Knowing What to Account For

The financial management aspects of accounting for all the funds you receive and expend are critical elements of running your real estate rental property activities. After all, the ownership and management of even a single rental property is a business, and the government expects you to have proper financial records in order to prepare your tax returns.

But proper financial management isn’t just for the benefit of the government. With accurate and timely information, you can manage your rental investment more efficiently and effectively. And when you decide to sell or exchange your rental property, your property will often generate a higher price if you have complete and accurate records, because buyers feel more comfortable knowing exactly what they’re purchasing. If you don’t have these records, the potential purchaser may err on the side of oversestimating your expenses, which will reduce his proforma calculation of the NOI that he will earn so he will decrease the price that he is willing to pay you accordingly.

New technology in banking is particularly helpful to the rental housing industry and is simplifying and expediting the rental collection and reporting procedures.

Some rental property owners now offer their residential and especially their commercial tenants the ability to make rent and other payments by automatic draft (automated clearing house, or ACH), or increasingly by electronic fund transfers to the property owner’s account on a predetermined date. Credit cards are another option for owners with many rental units (or small owners that use a property management company) although banking fees cut into your collected rents.
Even the traditional payment by check is enhanced with the advent of electronic check truncation, where smart phones or check readers or data entry software at larger residential properties can capture the salient information from the tenant’s check and immediately debit their account. This electronic processing shortens the collection time and eliminates checks or money orders being returned for nonpayment.
Online banking can also provide rental property owners the ability to make their own payments to vendors and suppliers electronically. Additionally, online banking provides access to records that immediately reflect all receipts and disbursements and minimizes the chance of fraud by employees handling cash by making the tracking of daily activity easier.

Documenting income and expenses

If your tenants pay by check, you can always let the cancelled check serve as the tenant’s receipt, but the best policy is to provide a receipt whenever possible, regardless of the method of payment. Likewise, track your expenses by using checks or credit accounts rather than making cash purchases for which you receive generic receipts, because the legitimacy of generic receipts can be challenged.

Keep your rental property activities separate from your personal transactions. Although the IRS doesn’t require you to keep a separate checking account for each rental property that you own, you need to be able to track the income and expenses for each property individually.

As you add rental units or commercial properties, the accounting becomes much more complex and the recordkeeping more critical. That’s when you must seriously consider hiring a property manager with good recordkeeping and accounting procedures who will create detailed monthly reporting that can be given to your accountant for tax planning and reporting.

Hiring a good tax advisor is a wise investment for even small rental property owners because tax rules are various and complex. For example, certain expenses can be classified as operating expenses and deducted in the current year to reduce your taxable income, but some expenses are considered capital items and must be depreciated or amortized over the estimated useful life of the improvement.

One of the advantages to owning real estate is that you can deduct all operating expenses from your rental income. These operating expenses include payroll, maintenance and repair costs, management fees, utilities, advertising costs, tenant screening fees, insurance, property taxes, and interest paid on mortgage debt. You also benefit from depreciation, which is a noncash deduction that reduces your taxable income in the current year but is recaptured in the future. Depreciation is discussed in more detail in Chapter 18.
Capital items typically include your building equipment or components that extend the useful life of the building and have a longer life span or are brand new, rather than routine maintenance or a repair. Your accountant is usually instrumental in providing guidance as to which items can be expensed versus the items that must be capitalized.
Rental property expenditures for capital items must be accounted for separately and are capitalized when their cost basis is depreciated or amortized over multiple years rather than deducted as an operating expense in the current year. This means that you aren’t able to reduce your taxable income by the full cost incurred but by a prorated amount over several years. Your accountant will generate depreciation or cost recovery schedules indicating the amount that can be deducted each year. Also, your accountant can keep you informed about changes in the federal tax code that affect depreciation deductions of certain capital expense items.
Some costs of financing, such as loan fees or points paid at the time of the loan, can’t be taken as an operating expense and must be amortized (taken incrementally) over the life of the loan. However, if you refinance or sell the property and pay off the loan, then you can take a full deduction of remaining unamortized loan fees in that tax year.

Be sure you accurately record the payment of a tenant’s security deposit. These funds aren’t typically considered income; instead, they’re considered a future liability that is owed back to the tenant if the tenant honors the terms of the rental agreement. The security deposit may become income at a later date if you apply any portion of it to cover delinquent rent, cleaning, repairs, damages beyond normal wear and tear, or other charges.

Creating a budget and managing your cash flow

Every rental property should have a budget, which is simply a detailed estimate of the future income and expenses of a property for a certain time period, usually one year. A budget allows you to anticipate and track the expected income and expenses for your rental property.

Many rental owners neglect to allocate and hold back enough money for projected expenses, so when it comes time to make a repair, for example, they don’t have the money set aside to cover it. If you set up a budget, you’re better able to anticipate your expenses.

Although the budget for a single-family or rental condo is fairly simple, a proper budget for a newly acquired multiunit apartment or commercial building can require some careful planning. That planning includes a thorough review of past expenses and the current condition of the property. Trends in expenses, such as utilities, can also be important when estimating the future cash flow of a rental property, so be sure you don’t overlook them. Check out the income and expense categories we cover in Chapter 12 — the process is essentially the same whether you’re formulating a prepurchase income/expense pro forma or the annual budget for ongoing operation of the property.

Many owners rely on cash flow from their rental properties not only to cover their expenses but also to supplement their personal income. But particularly if you’re a small rental property owner, you need to have a built-in reserve fund set aside before you start taking out any rental income funds for personal reasons. Maintain a reserve balance large enough to pay your mortgage and all the basic property expenses for at least two to three months without relying on any rental income. When you don’t have long term leases with stable tenants or the local rental market has low demand for your type of rental property, it may make sense to increase your cash reserves to an amount that allows you to sleep at night. Also, remember to allocate funds to cover semiannual and annual expenses such as your property taxes (if not impounded by your lender) and potential income tax due on your rental property net income.

Set up a bank account where you set aside money for anticipated major capital improvements. For example, you may own a rental property that will need a new roof in the next five years. Rather than see your cash flow wiped out for several months when it comes time to pay for that new roof, you can begin setting aside small amounts of money into a capital reserve account over several years. Lenders on large residential and commercial type properties often require the monthly funding of a capital item reserve and replacement account. For large apartment projects, this expense can be from $150 to $400 per unit per year. The owner can periodically submit requests (with copies of paid invoices) for reimbursement of qualified expenditures such as appliances, floor coverings, roofing, exterior painting, and other capital items.

Using Software

When you own several properties, consider using a computer with a spreadsheet or general accounting software program. Spreadsheet programs, such as Microsoft Excel, can handle a few rental properties. Somewhat better are the general business accounting packages, such as the entry-level Quicken, and the more advanced QuickBooks or Sage 50 Accounting. These programs can handle and streamline all the basic accounting requirements of managing a handful of rental properties.

Recognizing the value of professional accounting software

However, as good as these programs are, they lack the specific rental property features and reporting that are invaluable to effective property management. If you have more than five rental properties, we strongly recommend purchasing a professional rental accounting software program. These programs typically offer the following:

Complete accounting (general ledger, accounts receivable, accounts payable with check writing, budgeting, and financial reporting)
Tenant and lease management, including many standard rental management forms
Tenant service requests, maintenance scheduling, and reminder notes
Additional services such as electronic payments, tenant screening, payroll, and utility billing

Another advantage to using the computerized rental property accounting software packages is the ability to have your mortgage and other bills deducted electronically. Or you can work with these software packages to pay your bills online. If your tenants pay their rent electronically as well, you can decrease the time you spend handling rent collection and accounting.

Many property management accounting packages are available for a nominal investment, but don’t be penny-wise and pound-foolish. Many of the less expensive systems may work in the short run, but if something goes wrong, you may be left stranded without technical support or help. If a software firm has only a few systems in place, you’re in for a much higher risk of program errors or incorrect results. The software may not even be updated or supported years down the road. Your financial investment, and all the timesaving and other significant benefits of computerized accounting, may be lost if the software package isn’t backed by a solid company.

When you use a management company, you typically receive several important accounting reports within a couple of weeks after the end of each accounting month. If you review these reports regularly, they can provide you with a good understanding of your rental investments and give you the opportunity to inquire about or suggest changes in the operations. But if you manage your own property and do your own accounting, it’s important to actually review and analyze the financial reports in the same manner as you would if you had entrusted your investment to a property manager. You may think that you know everything you need to know about your rental property, and setting aside those monthly reports until tax time may seem harmless, but they’re great tools for improving your management results if you use them properly.

You can customize the financial reporting offered by software programs to meet your needs. Monthly reports often contain income and expense information compared to the monthly budget as well as year-to-date numbers.

Identifying some of the better programs

Each of the many program types available has its own strengths and weaknesses. Following are a few programs that we highly recommend:

Quicken Rental Property Manager (RPM): If you have a modest real estate empire of fewer than ten separate properties, you’ll find that this software package is affordable and acceptable option that’s superior to manual systems or user-customized computer spreadsheet software. Unlike prior versions, the more recent editions of RPM don’t require you to have the basic Quicken software to cover everything you need to prepare your own reports. These days, RPM is essentially an upgraded or specialized software built on the foundation of Quicken Home & Business and is fully integrated. You can even prepare your federal 1040 Schedule E to hand to your accountant or import directly into TurboTax if you prepare your own tax return.
On the downside, RPM is still primarily an accounting program that has been modified to handle some basic rental housing needs. It lets you write checks and even uses accrual (rather than cash basis) accounting, but it doesn’t include work orders, assist in preparing tenant notices, or have any of the other important features that can simplify your life as a property manager — features that are found in the more robust software packages that we recommend.

Additionally, RPM users report that even though the program has improved significantly in the past few years, it still has many blind spots when it comes to partial rent payments, coded expenses among various categories, and some of the other day-to-day issues faced by landlords. We suggest that you carefully follow the user reviews as subsequent versions are released and see whether the concerns about the product are issues that you find troubling. Clearly, if you own only a couple of single-family or condo units, you won’t have any problems. But if you have more units, if your income sources are complicated (such as miscellaneous income or if you accept rent from multiple roommates), or if detailed breakdowns of your expenses are important, then this entry-level product will frustrate you.

One aspect of RPM that we particularly like is that parent company Intuit seems to have made a commitment to this product and is introducing frequent updates that allow users to easily decide when the new features are worth the investment in the latest edition. But if you decide that changes aren’t really that important, the company continues to support its Quicken family of products for several years. For information on RPM and other Quicken products, go to http://quicken.intuit.com.
Rent Manager: One of the most popular software programs for landlords with small- to medium-sized portfolios who’ve outgrown RPM or simply need a more comprehensive software package than RPM is Rent Manager by London Computer Systems (LCS). LCS offers a Small Business Edition of Rent Manager that’s perfect for owners and managers with up to 175 units.
Rent Manager has everything you need, starting with a strong financial accounting package that includes a general ledger with accounts receivable and accounts payable, budget management payroll import, and financial reporting. The property management tools include rent collection (even preparing the bank deposit slips), tenant lease management, contact management and word processing (for correspondence and all types of notices), as well as a work-order module. We really like the built-in marketing features that allow you to monitor the results of your advertising, track your prospects, and even quickly post ads on Craigslist or to your own website.

Rent Manager is offered in an online version and a stand-alone version. We recommend the online version because you get automatic updates and LCS handles all data backup and technical support. Visit www.rentmanager.com for more details.
Yardi Voyager: For rental property owners or property management companies with portfolios of 250 or more rental units, we recommend the Yardi Voyager asset and property management software suite. Robert’s property management company uses this industry-leading, browser-based software, and he has been impressed with its ability to provide real-time daily and weekly reporting to effectively manage properties. Yardi Voyager also offers detailed monthly financial reports, which allow his company to provide a greater level of service to clients and outperform the competition. (See their full product line at www.yardi.com.)
Yardi Genesis: For smaller property owners and managers, Yardi Systems also offers a fully integrated, Windows-based product called Yardi Genesis that has much of the same basic functionality as Yardi Voyager but with less sophisticated reporting capabilities and fewer features and configuration options. Yardi Voyager is accessible anywhere via the Internet, whereas Yardi Genesis is accessible only through a local network. Like Yardi Voyager, Yardi Genesis includes all the basic features of prospect and tenant management, fully integrated accounts receivable and accounts payable, a general ledger, and cash management. It also allows ready access to information, elimination of duplicate entries, and spontaneous delivery of reporting.
Point2 Property Manager (P2PM): P2PM, another Yardi Systems creation, is geared specifically toward the small multifamily manager and is an easy-to-use property management and accounting software-as-a-service option. P2PM is easy to implement as well. Simply go to the P2PM website at www.point2propertymanager.com, sign up for a monthly or annual option, and begin using.

Yardi has a variety of pricing and hosting options for its software available on either a monthly or annual basis that can be based either on total program users or units. A variety of optional modules are available to enhance internal operations, streamline processes, and increase service level to residents and clients.

When evaluating different software packages, gather as much info as possible. Be sure to talk to actual product users, preferably people in your area with comparable rental properties and similar accounting needs. Determine what features a program offers, how easy it is to operate, its computer hardware requirements, the availability and cost of technical support, and the strength and reputation of the company backing the product. Obtain a demo or trial version of the software that you can use before you buy, just to make sure it’s truly what you want.

Just like with any technology product, another factor to keep in mind is not just whether the product meets the current standards but whether it incorporates or has the ability to upgrade and include the latest trends. The current trends in the rental housing industry software that you should look for include web-based Software as a Service (SaaS), subscription-based software, automatic posting of vacancies on Craigslist and other sites, integrated hosting and management of websites, electronic maintenance work order requests, electronic rent collection and bill payment, and integrated credit checks and applicant screening.

Recordkeeping and Accounting