There are many risks of mixing a person’s money with rental property money. While it may be simple to do so, it can create confusion in your accounting, generate additional taxes owed, and also jeopardize the liability protection of your business. Fortunately, it is easier than you would imagine to separate your financial activities.
Read this article to help you to identify and eliminate these risks by providing you with simple actions to clean up your financial accounting.
The Risks of Commingling Personal and Rental Funds
Although combining your personal finances with those for your rental properties may not seem like a big deal at first, it can create serious issues you could easily have avoided. Also, allowable deductions can reduce total liability if rental income is taxable.
Loss of Liability Protection
You are legally creating an issue as soon as you begin paying personal expenses from the same account you use to fund your rental property. When courts want to “pierce the corporate veil,” they are able to consider you personally responsible for property-related lawsuits.
This means that separating your funds and proving your company is a completely separate legal entity protects your personal assets, even if there are problems with one of your rental properties.
Tax Nightmare and Audit Risks
Using commingled accounts makes filing taxes confusing. You will be reviewing months of bank statements, etc., and attempting to determine which purchases were personal and which were rentals. The potential for audit exists anytime the IRS reviews your records.
When records are unclear, the IRS sees this as suspicious activity. For example, if you miss deductions, misreport income, or fail to explain transfers made during the year, you may incur fines. Maintaining clean financial records from the onset of your business will help minimize the amount of time spent on audits and ensure you report your income accurately.
Distorted Financial Tracking
The inability to track actual cash flow due to using commingled accounts to fund both personal grocery shopping and tenant rent deposits will cause confusion.
It is possible that you believe a certain property is making money because the large amount of money you spend on yourself hides a loss, or you spend too much of the rental income on yourself, causing the property to lose money.
Using separate accounts for each expense type allows you to receive accurate information. This clear picture enables you to plan repairs, such as water heater repair services, set rent levels appropriately, and determine when to invest in purchasing another unit.
Step-by-Step System to Separate Finances
Setting up a clear division of assets doesn’t have to be complex. By following these easy steps, you will protect your assets and make bookkeeping much less complicated. Here’s how to set up your system correctly.
Set Up Business Entities
If you don’t already have one, consider forming an LLC or similar entity for your rentals. This step legally separates your business from your personal life. Then run all rental activity through that entity. It is not just paperwork; it is also your first line of defense if a tenant ever sues you.
Open Dedicated Bank Accounts
Never mix rent deposits with your personal paycheck. Open a checking account and a savings account strictly for your rental business. Pay every property expense from that account. Tracking income and costs will be simple. At tax time, you will have clean statements instead of a jumbled mess to sort through.
Use Payment Tools
Manual checks and cash get messed up fast. Use online payment platforms that deposit rent directly into your business account. Many of these tools also track late fees and send reminders automatically. For expenses, use a separate business credit card. That way, each transaction will be in one place, and you will never lose a receipt again.
Preparing for End-of-Year Taxes
Before December is over, your tax preparation work should be just an easy check-up rather than a mad scramble for the last minute. If you have all of your business money in separate bank accounts and are using the proper software, you’ll have completed most of the major legwork by now.
To wrap up the year successfully, follow these steps:
Reconcile Your Statements Monthly
Every month, take some time, at least an hour, to go through your business bank statements. Be sure to flag any transactions that appear to be inaccurate or out of line. Also, make certain you can find receipts for everything. The less often you do this, the more likely it is that when you get ready to file your taxes, you will discover errors that could have been easily avoided.
Classify Expenses Throughout the Year
Track repairs, maintenance costs, insurance premiums, and management fee charges throughout the year by labeling them as many bookkeeping programs will do this for you. Once your categories are organized, your tax preparer will be able to find the items that can be deducted quickly without having to ask you numerous questions.
Gather Third-Party Documents Early
Examples include 1099’s from property managers, statements showing mortgage interest, and insurance policies. Create an electronic document storage folder and place all received documents in it once they have been scanned. Having these documents ready to go at the beginning of tax season is far less stressful than trying to locate them later when needed.
Track Depreciation Schedules
Update depreciation schedules for your investment property and large capital expenditures. The things you own (property) and those you purchase, such as HVAC systems, roofs, etc., are depreciable assets. However, only when updated and correct can these be claimed as deductions against taxable income.
Meet With Your Tax Professional Before Year-End
Set up an appointment with your tax professional before the end of the year. Even though there may be little you can do about last year’s tax liability, you should meet with your accountant in late fall. Many options remain available to reduce your tax burden. These could include making some prepayment on your taxes, or even planning for future capital improvements. Doing so gives you time to take advantage of any opportunities that arise.
Conclusion
The separation of your rental and personal financial accounts is not only good accounting practice; it helps to maintain your assets and improve your decision-making. It requires some effort to set up for the first time; however, once you have an established process in place, you will ask yourself, “Why did I wait so long?”
Therefore, begin now by opening one account using one program. You should also consider partnering with local property managers to optimize operations. Bay Property Management Group can help reduce turnover rates through proactive property management. Your future self and accountant will appreciate this.