Forensic Testing of Real Estate Rental Activities
By Joseph DeCusati, CPA, ABV, ASA, CFE, Managing Director, Valuation & Litigation Support Services
Members of the Marcum Advisory Group are often asked to provide a wide array of services to legal counsel representing divorcing individuals or individuals involved in commercial litigation. It is not uncommon for individuals who hold business interests to also hold interests in rental real estate activities. In some cases, the cash flow available to the owner of a rental property is just as important to the litigated matter as the value of the individual’s business assets. So, we are asked by counsel how we can accurately determine the real cash flow from commercial or residential investment properties.
As real estate prices continue to rise and commercial lenders become increasingly aggressive in their loan practices, investors are finding multifamily properties especially attractive. The potential for real cash flow is a significant incentive to add a rental property to an investment portfolio.
However, many real estate investors undergoing litigation find it difficult to document the limited amount of income they receive from these properties as reported on their income tax filings. This can lead to all types of issues for those involved in a litigated matter.
Forensic experts are sometimes asked to provide professional opinions and testimony relating to the earnings and cash flow from the real estate operations of individuals who possess an ownership interest in operations. There are several reasons why such analyses are requested, including:
- To determine the true amount of income available for purposes of support in a divorce (or post-judgment) when one, or both, of the parties derives income from real estate assets.
- To assure passive partners that they are receiving their “fair share” of partnership cash flow.
- To allow active partners to provide the necessary assurance to the passive partner – oftentimes when allegations of false reporting have been made.
While there are several areas of concern to be considered when initiating a forensic evaluation, a systematic approach can be employed to structure the engagement.
Numerous operational documents are used in performing a forensic analysis including, but not limited to, bank statements with deposit tickets and canceled checks, leases, income tax returns, appraisals, rent rolls, accounting reports, sworn financial affidavits, and so on. The documents required depend on the scope of the engagement. Some documents are essential to the analysis, while the absence of other documents can be overcome with alternative testing procedures.
A typical starting point is income tax returns and other documents that report financial activity for the properties. These documents provide a historical trend for rental income and deductions, allowing an analyst to compare data over time. They also provide a potential preliminary assessment of the properties’ operations and earnings capacity.
In a divorce, financial affidavits filed during the pendency of the action can be tested to determine if rental income and deductions accurately reflect the actual gross earnings and cash flow available to the properties’ owners. Information contained on these financial affidavits can also be analyzed and compared with the property’s income tax returns.
Determining the maximum potential for each property’s rental income is often the first step. We begin by gathering the units’ leases and creating a spreadsheet to reflect a monthly rent roll.
The terms of the lease help define the maximum amount of rental income available from the property. If operating expenses are reimbursed by the tenant as part of the lease agreement (i.e., triple net lease arrangements), those amounts would increase the capacity of total rental income. Those reimbursements would be a separate part of the analysis, however, and should not be considered in this test of gross potential rental income.
Next, rent rolls and deposit tickets are analyzed to determine if a rental unit was unoccupied, not rented, occupied for personal use, or under renovation. All would result in reductions from the maximum amount of potential rental income. Deposit tickets, checks that accompany each deposit ticket, and cash receipts can be used to verify the payments that comprise each deposit. It is important to note that establishment and implementation of basic internal controls will allow an owner to perform the fundamental elements of this analysis periodically without the need for an outside professional. Internal controls may also reduce contentious issues between partners in the future by letting all owners understand the income streams in an unbiased manner.
Ancillary Income Sources
Owners of an apartment complex sometimes benefit from various ancillary sources of income, such as vending machines or laundry operations. At times, this ancillary income can be material. A passive investor skeptical of the manager’s activities will want an accounting of this income and internal controls to be in place.
Deductions purported to relate to property management should be scrutinized. Whether records maintained are manual or computerized, there should be a simple trail to support the deductions claimed in the financial reports. These individual postings should be traceable to an invoice detailing the expense. Analysis of the invoice should provide data that corresponds to the posting.
Cash Flow: Depreciation
While a passive investor may only have access to income tax returns that report the financial activity of a property, it is important to remember that it is not the net income produced by the property that is distributable to its partners – it is its net cash flow.
To properly derive cash flow, adjustments for non-cash expenditures such as depreciation and amortization are made. When a partner receives financial documents (i.e., a Schedule K-1) that report minimal profits (or a loss), it does not necessarily mean that there are no cash flows available for distribution. These non-cash expenditures need to be “added back” to reported profits of the property to calculate the cash flow distributable to partners.
Cash Flow: Capital Expenditures
Similarly, capital expenditures should be considered in the analysis of cash flow available to the property owners. Analyzing the property’s fixed asset schedules may reveal that the property was enhanced by capital improvements. Often, banks require that a portion of the monthly mortgage principal payment be escrowed for future capital renovations. The purpose is to protect the bank’s collateral investment by compelling disbursement of these escrowed proceeds, thus maintaining its value. While capital expenditures and escrowed funds do not affect the profitability of the property, they can affect the cash flow available to its owners.
Cash Flow: Principal Repayments
While principal payments made on rental property mortgage obligations are usually cash flow adjustments, when reconciling income tax profits to owner cash flows, there may be an important distinction to be considered, depending on the engagement’s purpose. When a mortgage payment is made, the portion that represents principal obligation increases the net assets of the payer. Consideration of the principal repayment as a deduction from cash flows provides owners with the benefit of an increase in personal (or enterprise) wealth, as well as the ability to adjust their income for purposes of support in a divorce or post-judgment.
In such engagements, we often provide a dual set of results – one that does not consider the principal portion of these payments to be appropriate reductions of cash flow, and one that does consider the principal repayment. This can become a contentious issue among partners, particularly when the active partner is interested in decreasing the financial leverage of the property and the passive investor is interested in gaining access to all available cash flows. Further, when principal payments are accelerated beyond the agreed upon repayment schedule, questions may arise as to whether the payor accelerated payment to artificially reduce cash flow available from the property.
Testing Actual Distributions
Analyzing the actual distributions made from the property’s checking accounts to each of the partners can serve as a reasonableness test of the total cash flow available to a passive investor. Particular attention should be paid when the subject period includes a refinance that has allowed cash to be infused into the partnership accounts. Executed copies of closing documents should be produced whenever possible to confirm amounts received as a result of the refinance. Documents produced to the lender during refinance can produce useful information relating to the “true” cash flows derived from the subject property.
An analysis of total deposits into an “operating” bank account specific to rental activities can be performed. Adjustments should be made for deposits not identifiable as receipts of rental income. When complete, this analysis should reveal total deposits related to rental activities, which should correspond to rental income reported by the cash-basis rental property operation. Oftentimes, there is an underreporting of rental income deposits for the property which, in some situations, could be material.
Analysis of canceled checks should be performed when there are questions about vendors being paid from the property’s checking account. We recommend that the recipient of the payment be traced from the accounting records to the canceled check. Also, tests can be performed to determine if the payee is a legitimate business entity or related to the property manager or active partner. Special attention should be given to the recipients of payments for amounts in round numbers.
Maintenance of Business Records
Real property investors face the same requirements to substantiate claimed deductions to taxing authorities as other business owners. A passive investor should inquire about and test the internal controls and recordkeeping systems of the operation. Upon an IRS audit and income adjustment, the passive investor would be equally subject to the tax, interest, and penalties as the active investor for their pro rata profits interest.
The above represent only a sampling of the tests that can be performed to analyze the cash flow available to investors of a real estate operation. Often, tests can be designed to meet the specific nature of the investment. Performing these services can be helpful in adding value to your investment, as well as providing peace of mind.
NOTE: Significant components of this article appeared in the Connecticut Law Journal in 2012 and have been updated where appropriate.