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GAAP for real estate transactions part 3

GAAP for real estate transactions - Part 3

Posted by ,  on 30 July, 2015  5 minute read

For all those CPAs out there who are looking at accounting for real estate, this week we are considering the different forms of continuing involvement with the property and the accounting methods that should be used. Depending upon these various scenarios, the correct accounting methods are as follows:

  • The seller has partially sold the property. Partial sales consist of those in which the seller maintains an ownership interest in the property or has an ownership interest in the buyer. In this situation, profit should be recognized only when:
    • The buyer and seller are independent of each other. If the seller has a non-controlling interest in the buyer, the seller should recognize profit in proportion to the outside ownership of the purchaser. However, if the seller has a controlling interest in the buyer, no profit should be recorded until it is realized by a sale to an independent party or by profits from continuing operations.
    • The sales price is reasonably assured of being collectible. If the sale is not reasonably assured, the installment method or cost recovery method should be used.
    • The seller is not obligated to support the operations of the property or its obligations to an extent greater than its ownership interest. If, in fact, the seller has to support the operations of the property or its obligations and the transaction is in substance a sale, the seller should record profit to the extent that the proceeds from the sale exceed all the costs related to the property that are the responsibility of the seller.
  • The seller is required to repurchase the property, or the contract contains an option that may be exercised by the buyer requiring that the seller repurchase the property. In substance, therefore, this transaction should be accounted for as a financing, leasing, or profit-sharing contract rather than a sale of real property.
  • The seller is required to support the operations of the property. If the degree of support provided by the seller is only for a limited amount of time, profit on the sale should be recognized on the basis of the services performed. This assumes, however, that profit should not be recognized until there is reasonable assurance that future receipts will exceed operating expenses, debt payments, and other contractual obligations. On the other hand, if the seller is required to support operations for an extended period of time, the transaction should be accounted for as a financing, leasing, or profit-sharing agreement rather than a sale. If the support period is not specified in the sales contract, it is presumed for at least two years beyond the date that rental operations begin. Revenue should be recognized on the degree of performance of the seller in this situation. If actual rental proceeds exceed operating expenses, debt service, and other contractual payments before the two-year period ends, profit may be recognized at an earlier date. If the sales agreement requires that the seller manage the property without any compensation at all or less than the going rates expected for such services, compensation should be estimated as income as the services are performed over the contract term when the sale is recognized.
  • The seller is a general partner in a limited partnership that has acquired an interest in the property and the seller holds a receivable from the buyer for a material portion of the sales price. In this situation, the transaction should be accounted for as a financing, leasing, or profit-sharing agreement rather than a sale of property.
  • The seller leases back all or a part of the property for the remaining life of the property. This transaction should be accounted for as a financing, leasing, or profit-sharing arrangement rather than a sale.
  • The seller contractually guarantees a return of the buyer's investment in the property or guarantees some return on the investment for an extended period of time. The transaction is a financing, leasing, or profit-sharing arrangement rather than a sale. Note: If the guarantee of investment return is for a limited period of time, the deposit method of accounting should be used until operations of the property cover the operating expenses, debt service, and contractual payments. Profit should only be recognized subsequently when required services are performed.
  • On sales of condominiums or time-sharing interests, profits should be recognized based on the percentage-of-completion method. The percentage-of-completion method should be used on the sale of individual units (of condominium units or time sharing interests) if the following criteria are met:
    • The buyer can no longer require a refund (except for non delivery of the unit or interest).
    • Construction is beyond the preliminary stage.
    • Sales prices are deemed to be collectible.
    • Enough units of the building project have been sold so that it may be assumed that the project will not become a rental property.
    • Total sales revenues and costs can be reasonably estimated.

If any of the aforementioned criteria were not met, the deposit method should be used. When all are met, the percentage-of completion method should be used.

  • Although the form of the agreement appears to be a sale, the purchaser of the property has an option to buy the property. In this situation, generally, the buyer makes a down payment and is not required to make any more payments on the property until certain conditions are resolved, such as obtaining a building permit or zoning modification. These transactions should be accounted for using the deposit method, and the funds from the sale are accounted for as a liability and recognized as income when the purchaser exercises the option or allows it to expire.
  • The seller sells building improvements and leases the land underlying the improvements to the buyer. In this situation, the entire transaction is accounted for as a lease if the land lease does not cover the entire economic life of the improvements or is not for a substantial period. If both of these criteria are met, profit should be recognized on the sale of the improvements at the time of the sale and measured by (1) the present value of the lease rental payments (not in excess of the cost of the land) plus (2) the sales value of the improvements less (3) the carrying value of the improvements and the land. The seller should record profit on the buyer's rent payments that are made if they exceed the land's cost and the rent is received after the primary debt on the improvements is paid off. The profits should be recognized when:
    • The land is sold, or
    • The rents in excess of the seller's cost of the land are earned under the lease.
  • The sales contract requires that the seller is obligated to develop the property in the future. In this case, if such obligation exists, or the seller is required to extend the facilities in any way, the percentage-of-completion method is commonly used to account for the sale.
  • The sales agreement calls for the seller to partake in the future profits of the property without the risk of any loss. In general, if this transaction qualifies for the full accrual method of accounting and the seller partakes in future profits in the property without risk of loss, then the risks and rewards of ownership and the lack of continuing involvement are considered to be met. Future profit is recorded in the accounting period when the profits are in fact realized. All costs of the sale are recognized at the time of the sale. Specifically, no costs are deferred to periods when contingent profits are realized.

Next week we will have our final part in this series and topic will be “Retail Land Sale. To know what does GAAP mean for CPAs specializing in real estate check Part 1 and check Part 2 for different methods of sales of real estate”.

Hardik Shah
AUTHOR Hardik Shah

The QXAS Inc team is headed by CPA Hardik Shah, who is a member of the Colorado CPA Society. He also manages the training department which ensures all accountants stay abreast with the latest changes to US GAAP and FASB accounting standards.