GAAP for real estate transactions part 2

GAAP for real estate transactions - Part 2

Posted by  on 17 July, 2015  5 minute read

A recent Realtor.com survey of visitors to their site in mid-June showed that more US millennials indicated they were planning to buy a home in the next three months and that is good news for real estate CPAs.

Now is a great time to brush up on your skills and our CPA, Hardik Shah is going to look at sales of real estate other than retail land sales in this week’s review of GAAP for real estate transactions.

Sales of real estate other than retail land sales may be accounted for using one of the following methods:

  • Installment method: Payments represent cost recovery and profit recognition
  • Percentage-of-completion: The amount of profit recognition is predicated on the relationship of costs incurred to the total costs to be incurred
  • Reduced profit method: Profit is deferred until payments are made
  • Deposit method: No recognition of profit at consummation of the sale
  • Cost recovery method: Profit recognition is deferred until the cash received exceeds the seller’s cost of the property sold.
  • Full accrual method: Profit is recognized when the real estate is complete and a sale has been completed.

A discussion of these methodologies follows.

The full accrual method should be used if the sale has been fully consummated. A sale has been fully consummated when:

  • All consideration specified in the contract has been exchanged.
  • The parties to the contract are fully bound by the contract.
  • All requirements that had to be satisfied to close the sale of property have been satisfied (eg, inspections, land surveys, title policies).
  • Any permanent financing that is required by the seller has been arranged.

The buyer's initial and continuing investments in the property are considered sufficient commitments to pay for the property. A purchaser's initial investment should include:

  • Any cash that was paid as a down payment.
  • The purchaser's notes payable to the seller together with irrevocable letters of credit from established lending institutions.
  • Any payments by the buyer to third parties to reduce any existing debt that may remain on the property.
  • Additional cash proceeds that were paid by the buyer as a required part of the sales contract (eg, points, prepaid interest).
  • Any other payments or considerations that have been sold or converted to cash to the seller.

The initial investment in the property is considered to be met by GAAP for purposes of sufficiency if it is at least equivalent to that which an independent lending institution would require for a loan on the same type of property at the same price. For example, the following are some examples of the minimum initial investments expressed as a percentage of sales value that would have to be paid in to satisfy ASC 976-605-25-4:

Property Percentage of sales

Land held for commercial, industrial, or residential development to commence within two years after sale

20

Land held for commercial, industrial, residential, development to commence after two years

25

Multifamily residence:/

 

    Primary residence:

 

        Cash flow currently sufficient to service all indebtedness

10

        Start-up situations or current deficiencies in cash flow

15

    Secondary or recreational residence:

 

        Cash flow currently sufficient to service all indebtedness

15

        Start-up situations or current deficiencies in cash flow

25

Single-family residential property (including condominium or cooperative housing)

 

    Primary residence of the buyer

5

    Secondary or recreational residence

10

Note: Minimum initial investments for other types of property are specified in ASC 976-605-25.

Frequently, sales contracts relating to land sales contain certain provisions that require a seller to release a lien on a portion of property after receiving certain amounts of payments from the seller. The seller will release the lien only if it has obtained a sufficient amount of money that it believes places an acceptable level of risk on the remaining financing. In this situation, the initial investment of the buyer is considered to be sufficient for the property overall if (1) it is an adequate initial investment on the property not released and (2) it is considered adequate to cover the property released at the date of sale. If the amounts applied to the unreleased portions do not satisfy the initial (and continuing) investment requirements, each release should be viewed as a separate and individual sale.

The sale is not subject to future subordination. The seller's receivable should have a lien that is not subordinate to all other debt in the property except (1) a first mortgage loan existing at the date of sale or (2) a future loan provided for in the sales agreement assuming that any proceeds for loan repayment will be applied first to the receivable of the seller.

The sale of the property fully constitutes a transfer of all the risks and rewards of property ownership without any future seller involvement in the property. The fact that the seller has some sort of involvement may be indicative of the fact that the risks and rewards of property ownership have not, in fact, been transferred and a bona fide sale has not been made. For example, the seller may guarantee the buyer some purchase price rebate if a minimum return is not generated for the new buyer.

Additional requirements must also be met in order for a retail land sale to be accounted for under the full accrual method. ASC 976-605-25-6 requires that the following must also be met:

  • Development of the lots that have been sold must be complete.
  • The refund period has expired.
  • Cumulative payments are sufficient.
  • Receivables are subordinate to any debt on the property and are deemed to be fully collectible.

If these criteria are not met, revenue should be recognized under the percentage-of-completion method, installment method, or deposit method.

Here is an example of the full accrual method in action:

A company that develops land lots enters into a sales agreement with a contractor to purchase the land lots for $600,000. The agreement calls for the contractor to pay the development company $150,000 cash and a note for $450,000. The note is due in four equal installments, pays interest at the rate of 8%, is not subordinate to any new loans on the property, and is backed by an irrevocable letters of credit from an independent established lending institution. Land and development costs on the part of the development company equal $400,000. The land development company would make the following entry on the sale of the developed lots:

 Cash 150,000

 Note receivable

450,000

 Sales from lots

600,000

 Cost of lots

400,000

 Land and development capitalized costs

400,000

The full accrual method should be used when the aforementioned noted criteria have been met.

Hope that has brought you up to speed. Next week we will be looking at the different forms of continuing involvement with the property and the accounting methods used for them.

To know what does GAAP mean for CPAs specializing in real estate check Part 1.