The Sum of all Debits = the Sum of all Credits (eBook excerpt chapter 2.08)

A free sample from chapter 2 Accounting Fundamentals of our Landlord / Property Management in QuickBooks guide. Section 2.08 The Sum of all Debits = the Sum of all Credits. We hope you’ll become a customer today, or sign up for the free e-course.

 

As we talked about in recent posts about debits and credits, the accounting equation, and T-Accounts, there are basic accounting rules that, once learned, make complicated transactions simple.

The sum of all debits must equal the sum of all credits.

For one transaction (ex a Journal Entry), or for all transactions ever entered. It always is true.

If you have to enter a transaction that this book doesn’t have an example of, draw the T- Accounts and amounts involved. Try to figure out what to do, then talk to your accountant and confirm you have the correct method. The only time you use debits and credits is in Journal Entries, if the sum of all debits does not equal the sum of all credits, there is a mistake.

Keep moving through these sections, even if you do not completely understand them. The examples that follow will get you ready to work with QuickBooks. If you are terribly confused, that’s okay, skip ahead to the next chapter.
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Q&A: What is a Contra Account?

Reading about Accounting Basics, Landlording, and QuickBooks, you may have stumbled upon the term “Contra Account.”

What is a Contra Account?

A Contra Account carries a balance that is opposite the account type’s normal balance. Accumulated depreciation is a contra asset account. It’s an asset account, but increasing it decreases total assets. Contra accounts act to offset the balance in the main account.

Example: Accumulated Depreciation is a Contra Account. Normally asset accounts increase with a debit, but accumulated depreciation increases with a credit. Here I explained debits and credits, also in this Landlord Accounting with QuickBooks eBook excerpt.

Accumulated Depreciation is a Contra Asset Account. This is asset account which is expected to have a credit balance (which is contrary to the normal debit balance of an asset account). The contra asset account is associated to another asset account. For example, the contra asset account Accumulated Depreciation is associated to the Fixed Asset real estate account. Allowance for Doubtful Accounts is related to Accounts Receivable. The contra asset account Accumulated Depreciation is related to a the owned real estate you have capitalized and are depreciating.

The net of the asset and its related contra asset account is referred to as the asset’s book value or carrying value.

Normal Balance is an accounting classification of an account. It refers to the side of an account which increases the account’s balance. An account has either credit or debit normal balance. To increase the value of an account with normal balance of credit, credit the account. To increase the value of an account with normal balance of debit, debit it. A contra-account works in the opposite of a normal balance account.

 

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Rental Property Expenses versus Capital Improvements

As landlords enter transactions into QuickBooks, they must decide if something is an expense or a capital improvement. The impact is significant.

Example: You have a property that will earn $12,000 in gross rent this year (and $5,000 after insurance, property taxes, depreciation, etc). You bought if Jan. 1st this year for $100,000. You expect to pay taxes on the $5,000 in income.

The purchase price is generally capitalizable (some exceptions are if it was already rented and in the $100K you also received cash for the current tenant’s security deposit. Then you’d need to transfer the security deposit.) What if you need to put on a $3,000 new front porch and replace the carpet in the living room for $450? You’ll spend the money, but how do you record it in QuickBooks?

Let’s say you expense everything.

Your expected $5,000 in income is reduced to $1,550. “Great!” you may say, you pay less in taxes, because all repairs can be deducted from income in the current year. Your balance statement will not change, only your income statement. Is this correct? Is this legal?

Let’s say you capitalize everything.

You will still earn almost $5,000. You will have a more valuable asset on your balance statement, and you will have a little bit more depreciation to offset income (which is why you will be taxed on a bit less than $5,000). “Terrible!” you say, you pay more taxes and have to wait for years for depreciation to offset income which could have happened all at once if you only expensed it. Is this correct?

The problem here is capital improvements must be depreciated. The problem with depreciation is you do not get to make a full deduction to your income in the year the payment was made.

What is the right way?

Generally speaking you do not have a say in what you can expense and what you must capitalize. The tax authorities have pretty clear guidelines. Everyone in the US should at least skim Pub 527 Residential Rental Property. You still get to deduct capital improvements from income to lower taxes, but they must be spread out over the particular asset’s depreciation schedule.
The IRS explains you capitalize what “extends the useful life” of the property. Examples of capital improvements:
  • replacing a roof
  • building an addition or a garage
  • replacing all plumbing, electric, or windows
Reparts are necessary to keep a property in working condition. The IRS says they “do not add significant value to the property or extend its life.” Examples of repairs:
  • fixing a bad patch of a roof
  • repainting a room
  • replacing bad flooring

What’s a smart landlord to do?

Skim Pub 527, but don’t stop there and try to do everything yourself. Many tax strategies have been tested in court and you need to find an accountant that can help you be aggressive, but entirely in compliance with what courts ruled and the IRS requires.

For instance, you may find some tax lawyers will advise you to expense most of the costs spent to bring a rental up to service, even if these would normally be capitalized in a very strict reading of the tax law. He or she will have very specific reporting requirements for you, fortunately these are quite easy when you set up QuickBooks correctly and have an organized office.

If you must depreciate, and you are operating a profitable company, then you can optimize current year’s deductions by using an accelerated depreciation schedule instead of a straight-line schedule.

The verdict? Set a goal this year to meet several new accountants and ask them about how they optimize taxes for other landlords. First meetings will be free, and you will be able to ask lots of questions and find someone who can help you find a legal balance between capitalizing and expensing your outflows.

Want more? Read our blog for other articles (like this one previewed from the training guide) or go ahead and buy the full course right now to learn how to use QuickBooks for Landlords and Property Managers. (We have lots of screenshots of how to enter expenses and capitalized transactions.)

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Q&A: Escrow Account for Mortgages

I recently received a question from R.C.

After reading your book How to Use Quickbooks for Rental Properties, I have a question about escrow accounts.

I set up a mortgage payment of $5300 a month. $4400 is principal and interest and $900 goes to an escrow account to pay taxes at the end of the year. When I look at the escrow account the payments show as debits and the balance is a negative number. At the end of the year I do a transfer from the escrow account to the bank account and then pay the property taxes? The transfer from the escrow account shows up a credit. Can you help me understand why this is from an accounting point of view?

Great question. Why is the escrow account balance negative? I predict it is the wrong account type. Also, probably you are writing your mortgage checks something like this:

escrow check payment for bank loan

The key is what type of QuickBooks account is the Escrow Account? Is it a liability, an expense, or an asset? Because you are accruing money in there that you will later use to pay an expense, it is an asset you own. Thus, in QuickBooks create it as an Other Current Asset account type.

other current asset escrow quickbooks

When you do it this way, you will have the correct balance for your escrow. (If it were a liability account, it would show a negative balance).

transactions by account

At the end of the year, you can record a Journal Entry for your total taxes paid from the escrow account, making sure to also record classes in all the line items.

pay property taxes from escrow quickbooks

It is likely you would actually have several line items on this journal entry. One for each property. You have a choice to also create sub-accounts for each property under the escrow account. Generally that is not needed, but if you want it is an option for more reporting granularity.

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Debits and Credits for Landlords in QuickBooks

When you’re a busy landlord using QuickBooks, you may just want to use QuickBooks and not have to think about journal entries, debits, or credits. And, generally the way we teach things, you can do that. However, sometimes it is very useful to think about transactions as Debits and Credits.

“Accounts” are just a collection of transactions that sum up to give a current balance. There are always two kinds of transactions that come into play: a debit or a credit. In the image above, you can see the shorthand notation used, a “T-account.” where debits are on the left and credits on the right.

It depends on the account type if a debit increases or decreases the balance

This is just the way accounting works. A cash account is an assets, and they increase with a debit; but liability accounts increase with a credit.

cash and liability T-Account quickbooks

The example transaction below shows the two accounts involved in creating a loan. It increases your cash, and increases your liabilities.

cash and liability T-Account example deposit a loan

In any given transaction the sum of all debits must equal the sum of all credits. Here 500 equals 500, perfect.

In QuickBooks for Mac, the Journal Entry would look like this:
mac journal entry

Or for Windows, it would look like this:general journal short term loan windows

The equivalent could also be a deposit like this. It is not a Journal Entry directly, but it creates one behind the scenes.
quickbooks make deposit mac

You can verify the deposit creates the equivalent Journal Entry by opening up the Petty Cash register and highlighting the transaction. Then click Reports > Transaction Journal. In the mac version the following opens up. It’s equivalent for windows or online.
transaction journal

Use this chart to help you remember if a Debit or Credit increases each account type’s balance.

Extracted from page 23 of our training guide, the below graphic is a quick reference when you need to make a Journal Entry. Consult it to review which account increases by a credit and which by a debit.

debits and credits T-Accounts quick reference

Read more about this is our free debits and credits excerpt from the eBook.

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