So you bought a rental property and know that you need to keep good financial records. You see the funds transfer out of your bank account and are ready to record the transaction in your books. But how?
Creating a journal entry from your buyer’s closing statement is one of the more complex transactions on the way to properly keeping books as a real estate investor. It is also one of the more important - calculating your basis in a new property is the starting point for all future depreciation, capital gains, or 1031 exchanges. Additionally, many expenses that can be immediately deducted as an investor are on the closing statement; if you miss them you’ll be stuck with a higher tax bill than necessary.
Some CPA’s will prepare closing journals for you. Since these are your financial records though, your understanding is still important. If you are the DIY type, don’t have an ongoing engagement with a CPA, or work with a generalist tax preparer who is not as familiar with real estate transactions, you may also be taking on this task yourself.
In this article, we’ll explain what a closing statement is, walk through the types of line items typically present, and show you a sample journal that correctly fits the pieces together.
What is my buyer’s closing statement?
Your closing statement is the form which lists the property to be transferred, any borrowed funds, and all costs to complete the transaction. Different forms are used depending on the requirements of the transaction and the lawyers involved. The three most common are:
The HUD-1 Settlement Statement: This form lists both the buyer’s and seller’s side of the transaction and is signed by both parties. It is published by the US Department of Housing and Urban Development. You’ll want to look at the buyer’s side, which is separated into credits and debits. Debit amounts increase the total you owe to complete the purchase, and credits reduce it.
The ALTA Settlement Statement: This form shows one or both sides of the transaction. It is signed by the borrower and countersigned by a representative of the title agency. The form is published by the American Land and Title Association - the industry group of title insurance companies. Like the HUD-1, amounts are split into credit and debit columns. Debits increase the amount owed; credits reduce it.
The Closing Disclosure: This disclosure is prepared by your mortgage lender. In addition to the closing statement, it contains a summary of the loan terms, paydown, and escrow. It comes in a standard layout published by the Consumer Financial Protection Bureau. There are no credit or debits. Amounts owed versus paid are split into separate sections, and negative numbers are used if necessary.
Any of these documents will contain the information that you need to prepare a closing journal entry. Due to the differences in the forms though, as well as differences between each real estate transaction, correctly recognizing and categorizing information requires both good understanding and attention to detail.
Calculating your starting basis in a rental property
The first line of a closing statement is the purchase price. This, along with the property’s most recent tax assessment and any seller credits, is what you need to calculate your starting basis in the property and begin to create your closing journal.
First, look up the most recent tax assessment for the property. If you don’t have this information already, property tax assessments can usually be found on the website of your local government. The assessment will be broken into the land value and value of buildings/improvements. You will need to determine the ratio of the buildings/improvements value to the total property value.
For example, land valued at $20,000 and buildings/improvements valued at $80,000 would give a ratio of $80,000/$100,000 or 0.8.
Once you have the building ratio, multiply it by your purchase price less any seller credits (the effective price) to determine the building value for your journal. The land value will equal the effective price less the building value. Both buildings and land appear as debits in your journal to establish them as assets on the balance sheet. Calculating this split is important because the building value will depreciate over the course of your ownership of the property while the land will not.
Capitalizable closing costs for rental property
The IRS has designated a number of closing costs as capitalizable. This means that they cannot be deducted immediately, but instead are added to the building basis and depreciated according to the useful life of the property (27.5 years for residential buildings, 39 years for commercial). The most common of these closing costs are title fees/insurance, surveys, recording fees, legal fees, and transfer taxes. Any amount you agree to pay on behalf of the seller, such as back taxes or real estate commissions, is also capitalized.
Find each of these lines on your closing statement and add them up. To add this total to your journal, you will need a fixed asset account for capitalized closing costs. Use this account to add the total as a debit.
Tax deductible expenses from the closing statement
Several expenses normally deductible on an investor’s Schedule E frequently appear on the closing statement. These include property taxes, prepaid mortgage interest, assessments from an HOA, and insurance. There is no difference in reporting for these expenses when they occur as part of closing than in any other case. Simply add them as debit lines on your journal; they will flow through to your net income statement.
In some cases, the seller may have already paid a portion of the expenses due for your new property. These will appear in a section as adjustments for items prepaid by the seller. Increase the debit line on your journal for any amount shown.
If the prior owner left bills outstanding, there may be adjustments for items unpaid by the seller, which decrease the total you owe at closing. Add a credit line (or reduce the existing debit) for the account of any amounts shown.
Capitalizable closing costs of mortgages
In addition to the capitalized closing costs tied to your property, most costs associated with obtaining a loan must be capitalized rather than immediately deducted. These include loan origination/processing/underwriting fees, purchased points, appraisals, credit reports, etc. Add them up from your closing statement. These will become another capitalized closing cost line in your journal.
Unlike the property capitalized costs, loan costs will amortize according to the duration of the loan (15 years, 30 years, etc.). This means that their accumulated depreciation and remaining basis will need to be tracked as a separate asset, unlike the capitalized property costs which can be rolled up with buildings. If you pay off your loan early or refinance the property, you will be able to expense any remaining capitalized loan costs at that time.
Loans, escrow, earnest money deposits, and closing cash
If your property was financed, a large portion of the final payment will have been made on your behalf by your lender. You should create a liability account in your chart of accounts for this loan. Add the loan amount to your journal as a credit to reflect the lender’s payment. This entry will also establish the starting loan balance on your balance sheet.
If your loan uses an escrow account to pay for periodic expenses like property insurance, taxes, or HOA fees, you may need to pre-fund this account to meet a certain balance. If your closing statement provides line items for these expenses, you can ignore them and just focus on the total - the line items are best guesses since the expenses have not been paid yet. In addition to expense estimates some statements will also show a credit that reduces the total escrow funding. Add a line to your journal for the escrow account debiting the total pre-funded amount.
At closing you’ll receive credit for any earnest money deposit that you made for the purchase. Credit this amount in your journal to Earnest Money Deposits or whatever account you used to record the deposited funds. If you originally paid this expense out of pocket and have not previously recorded it, add the amount to owner’s equity.
The “cash to close” or “amount due from the borrower” should be the final line on your closing statement. This should match the withdrawal from your business’s bank account or equal the amount that the owners are contributing to the business to complete the purchase. Add this amount to your journal as a credit pointing to either the bank or appropriate owner’s equity account.
A sample journal
The following journal is created from this ALTA Settlement Statement. The property was assessed at $40,000 land value and $125,000 building value. Note the use of offsetting Auto-Balance lines to split the journal into two entries that can be attached to the two fixed assets (the property and capitalized loan closing costs) which should be created.
The property purchase journal:
The loan origination journal:
As you can see, properly analyzing and recording your closing statement touches multiple balance sheet accounts as well as the income statement. Getting it right is important because the journal establishes your basis for the lifetime of your property and may contain substantial deductible expenses. Your CPA may assist you with this analysis as part of your tax preparation or for an additional fee. Alternatively, use the links below to learn more REI Hub and how our automated real estate accounting helps you simplify the bookkeeping for your rentals. Thanks for reading!