Key Takeaways
- Many private equity commercial real estate sponsors miss the IRS deadline for providing Schedule K-1s to investors.
- Late K-1 dissemination is largely due to gaps in accounting operations among sponsors.
- There are five key steps that commercial real estate sponsors can take to improve accounting practices and promote timely K-1 delivery.
In the world of private equity commercial real estate, the delivery of Schedule K-1s to investors after the IRS-stipulated deadline of March 15th is an unfortunate reality for many funds and syndication groups. Sending K-1s after March 15th, and especially after April 15th, puts investors in a difficult position because it forces them to file an extension and then advise their accountant to wait for the K-1 to be delivered before filing a tax return.
From our standpoint as a fund administrator that offers accounting and bookkeeping services to commercial real estate funds and syndicators, the prevalence of late K-1 delivery is largely due to sponsors maintaining poor accounting operations. The good news is that there are five steps that sponsors can take to ensure that K-1s are prepared and delivered to investors by March 15th.
1. Use the Right Accounting Software
While not a best practice, it’s possible to use generic accounting software when starting out managing small sums and small portfolios. However, when the portfolio and transaction volumes grow, using generic accounting software becomes impractical because it is not capable of automatically classifying and creating journal entries for common real estate transactions like the allocation of late payments between rent and security deposit money, move-out transactions where security deposit money is held back, public housing authority payments, etc. Attempting to enter, classify, and organize transactions like these during tax season is a common cause of delayed K-1s.
At some point in the lifecycle of a private real estate investment strategy, it will become necessary to migrate to accounting software that caters to the real estate investment industry. The good news is that these tools tend to include functionality beyond core accounting (property management, owner portals, etc.), but there is also a learning curve for sponsors who do not have prior experience.
2. Design the Chart of Accounts to Reflect Business Practices
A chart of accounts is a systematic organization of financial categories and subcategories used to track income, expenses, assets, and liabilities related to real estate investments and operations. Every accounting software offers a standard chart of accounts out of the box, but this isn’t adequate for most CRE investment shops. Neglecting to tailor the chart of accounts to the nuances of the business tends to result in unorganized books, and when tax season rolls around, sorting through a web of transactions can take time and cause K-1 production delays.
A chart of accounts should be designed to reflect commercial real estate industry practices and should accommodate the common transactions entered into by a commercial real estate investment firm. As a matter of best practice, the chart of accounts should be designed when the accounting software is acquired because this sets a strong foundation and positions the bookkeeper to make additions and modifications over time. Perhaps most importantly, a well-designed chart of accounts promotes sound transaction classifications, which facilitates timely K-1 delivery.
3. Eliminate Accounting Knowledge Gaps Among Staff
People who manage commercial real estate funds and syndications are typically real estate people, not accounting people. Unfortunately, in many cases, the folks managing the properties are also not very fluent in accounting principles. This can lead to incorrect accounting entries throughout the year, which must be addressed before K-1s can be produced.
Training staff members in accounting and bookkeeping takes two general forms. First, it is important that the people who are responsible for keeping the books, or even property managers who are responsible for making individual entries, are trained in the basics of accounting. Second, all users of the accounting software must be trained to use it correctly within the parameters of their role. This can be a significant undertaking for a growing private real estate investment firm, but it is also a major risk mitigator that can eliminate many of the causes behind delays in K-1 delivery.
4. Hire a Specialist Bookkeeper
A bookkeeper can make or break the timely production and delivery of K-1s. Good bookkeeping in the commercial real estate industry obviously requires knowledge of basic accounting principles, but the need to understand the intricacies of real estate transactions – purchases, refinances, construction draws, etc. – is very underappreciated.
Unfortunately, many sponsors are surprised during tax season when they learn that a generalist bookkeeper incorrectly booked major transactions or omitted entries throughout the year. The harsh reality is that bookkeeping knowledge gaps can lead to significant delays in the production of K-1s. On the other hand, working this a sophisticated bookkeeper with commercial real estate experience is very likely to result in sound financial statements that a CPA can use to deliver K-1s accurately and on time.
5. Maintain Documented Accounting Procedures
When meeting with a new client for the first time, we always ask about the steps they take to close their books every month. Too often, we get a blank stare or an embarrassed look that lets us know the client has never gone through the process of formalizing and documenting a month-end close process.
Establishing a written, monthly process to review the accounting entries made during the month is one of the best ways to detect incorrect or missing entries. We have worked with many CRE investment firms to develop comprehensive accounting procedures, and virtually all of these sponsors have continued to produce K-1s on time year after year.
Final Thoughts to Make Sure K-1s Go Out on Time
To the dismay of investors, many commercial real estate funds and syndicators struggle to deliver Schedule K-1s to their investors on time. The good news is that there are fundamental steps that a sponsor can take to streamline the production and delivery of K-1s.
Specifically, sponsors should be sure to choose the right accounting software, set up the chart of accounts properly, engage a qualified bookkeeper or fund accountant, and train employees on well-designed accounting procedures. Taking these steps will help private equity commercial real estate investment firms to operate on best-in-class accounting principles, deliver K-1s on time, and stand apart from the competition.
Lexcraft Advisors is a fund administration provider that serves middle market real estate investment funds and syndications, typically with equity under management between $15 million and $100 million. Our team takes pride in providing general partners with reliable fund administration solutions often reserved for large, global investment firms. To learn more about our services, schedule a complimentary meeting with one of our Managing Partners.