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Real estate entities will need to evaluate their revenue recognition practices as a result of the new revenue recognition standard.
The primary source of accounting for real estate sales is the FASB’s Statement 66, which establishes a scheme for recognizing revenue under varying conditions.
The threshold question in a real estate transaction is whether there has been a “sale.” Under Statement 66, there is a two-part conjunctive test: 1) is the sales price definite and assured of collection; and 2) is the seller under any continuing duty post-sale? Any such post-sale obligation will invalidate the sale for revenue recognition purposes.
Assuming these two conditions are met, the sale is consummated. In tax terms we would say it’s a completed transaction, and a real estate salesperson would say it’s gone through closing.
An advisor or real estate salesperson may be confused by Statement 66 because its focus, rightly, is on the economic substance of the transaction. However, in the realtor’s world, there is only the sales contract (the standard contract for sale and purchase — usually approved by the state association of realtors and the state bar association) and closing. To get from the contract to closing is no easy matter. Statement 66 therefore presumes that sale consummation occurs at closing, not at execution of the sales contract. The subject property may never be sold if one of the contingent conditions of the contract (such as the buyer obtaining financing) is not met. Procedure IND-II K1 lists the steps required in a typical real estate sale before a closing results from a sales contract.
Revenue recognition occurs under the following accounting methods once a sale has been consummated.
Full Accrual Method: For the real estate industry, Statement 66 tweaks the accrual method by expanding the basic accrual method to the full accrual method, demanding that:
The sale is consummated (see above);
Initial and continuing investments by the buyer in the property are sufficient;
All the risks and rewards of ownership reside with buyer;
There is no continuing duty or involvement by the seller post-sale (after closing); and,
There is no future subordination of any buyer receivable (seller financing cases).
While the full accrual method closely resembles the basic accrual method, the modifications listed above, such as for seller financing cases, are crucial. Note also that Statement 66 distinguishes between different types of real estate sales; for example, between a developed property sale and a retail land sale such as of raw land. In a raw land sale, the full accrual method only applies if:
The refund period expires for buyer’s deposit or payments;
Cumulative principal and interest payments equal at least ten percent of selling price;
A down payment of at least 20%. If not, then at least 90% of current raw land sales contracts must be collected in full if such contracts are not cancelled within six months of their recordation in public records. This latter point ensures that the raw land contracts satisfy the full accrual method;
There is no subordination of the buyer’s receivable unless a home construction loan is superior; and
The seller met its obligation by completing any land developments.
Regardless of the type of transaction — developed realty or raw land — the revenue is recognized at closing if the Statement 66 conditions for the full accrual method are met.
If any of the Statement 66 criteria for the full accrual method are not met, then the statement prescribes one the four accounting methods for revenue recognition described below.
Deposit Method: No revenue is recognized and no buyer’s receivable is recorded at the closing date. Instead, the seller entity continues to carry the property on its financials primarily because of the uncertainty of the seller’s investment.
Seller entity sells raw land to Buyer who makes a 1% down payment, assumes secondary liability on Seller’s original note, and obtains seller financing for the balance. Seller financing is subordinate to the original bank financing and Seller remains liable. Such a transaction, not unusual in raw land sales, results in no revenue recognition at closing for Seller. Why? Because the economic substance of this transaction indicates that Seller still bears the risks and rewards of ownership. As Buyer makes payments on the assumed debt and Seller’s receivable, the principal payments on the receivable are reported by Seller as deposits on the contract and recognized at that time. The interest paid on the assumed debt does not affect the Seller’s recognition.
Cost Recovery Method: The seller does not recognize any revenue at closing but only when the buyer’s total payments (including any principal and interest on assumed debt or the seller receivables) exceed the seller’s cost of the property. Buyer payments initially reduce the seller’s cost, then any further recovery is profit that is recognized as revenue. Under Statement 66, this method is used only when substantial uncertainty exists as to receipt of the seller’s cost should the buyer default. Also, this method is rarely accepted for tax accounting purposes.
Installment Method: No revenue is recognized at closing except for any initial payments. Subsequent revenue recognition is based on a gross profit ratio. This method is one of the most frequently occurring methods used by sellers who do not qualify for the full accrual method of accounting under Statement 66, and the sales price is paid through seller’s receivable or assumptions.
Reduced Profit Method: This method employs a discounting technique. The buyer’s receivable is discounted to the present value of minimum annual payments due over 20 years for land debt, or over a normal term for other realty. Revenue is recognized at closing based on the sales profit less discount, and the discounted portion is deferred and recognized at the end of the discount period. This method is frequently used when a commercial development entails a long-term buyer’s receivable, such as 25 years.
In 2005, Developer entity completes a shopping center, leases it, and sells it to Buyer entity for $10 million. Developer has a cost basis in the center of $6 million, resulting in a profit of $4 million. As part of the sales contract, developer receives cash of $2 million and Buyer entity’s note of $8 million, which is collateralized by the shopping center. Its terms are 25 years with interest at the rate of 10% for annual payments of $872,400. A regional commercial bank lender would issue a first mortgage of $8 million over 20 years with interest at the rate of 8% for annual payments of $803,000.
Applying the Statement 66 reduced profit method:
Discounted present value (PV) of the note:
($872,400) x (PVIFA 10, 25) = ($872,400) x (9.077) = $7,918,775
Deferred revenue (gain):
(8,000,000 – 7,918,775) = $81,225
Recognized as payments are received over last five years in proportion to principal reduction.
Recognized revenue (gain) at closing (Selling Price – Costs – Deferred gain):
($10,000,000 – 6,000,000 – 81,225) = $3,918,775
The $4,362,000 representing the last five years (25 – 20) of payments (5 x $872,400) is allocated as follows (assuming a 70% principal reduction):
$3,053,400 principal allocation, and
$1,308,600 interest allocation
None of the $81,225 deferred gain is recognized until the end of the period used in the present value calculation or, in this case, the last five years.
For retail land sales, the revenue recognition methods are: full accrual method, percentage of completion method (PC), installment method, and deposit method. The PC method is described Construction.
Choosing the Correct Revenue Recognition Method
In summary, there are many variations in real estate transactions, but the basic rule in recognizing revenue is to focus on the nature of the underlying transaction, identify the Statement 66 constraints, and then apply the appropriate revenue recognition method. A realty entity such as a developer may wish to “plan around” Statement 66 to recognize revenue, in whole or in part, at an earlier point in the transaction by structuring the deal more carefully.
Other Than Retail Land Sales
Statement 66 provides guidance for recognition of revenues and profit on other than retail land sales (OTRLS). Under SOP 04-2, Accounting for Real Estate Time-Sharing Transactions, and FASB Statement No. 152, Accounting for Real Estate Time-Sharing Transactions — an amendment of FASB Statements No. 66 and 67, a seller of a time-share should recognize revenue and profit on time-sharing transactions as specified under the recognition provisions in the OTRLS sections of FASB Statement 66. Such sales must be nonreversionary; that is, title to the time-share must transfer at the time of sale; otherwise, SOP 04-2, like Statement 66, treats the transaction as if it were an operating lease.
SOP 04-2, also treats bad debts as a reduction in revenue, since time-share collectibles that “go bad” are, in actuality, sales returns and not an expense. In this way, such uncollectibles are given the proper contra-revenue account treatment, and not expense account treatment. SOP 04-2 is effective for financial statements for fiscal years beginning after June 15, 2005.
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.