Property Tax Accrual: The Correct Accounting Process
Learn the correct accounting method for property tax to accurately match expenses to the periods they cover, providing a true view of financial performance.
Property tax accrual is an accounting method that evenly spreads the cost of property taxes over the period they cover by allocating the expense monthly. This aligns with the matching principle in accounting, which dictates that expenses should be recognized in the same period as the revenues they help generate. Using this method provides a more accurate representation of financial performance by preventing the distortion of a large, single-month expense.
The Timing of Property Tax Bills
Property tax accrual is necessary because of a mismatch between how taxes are billed and the period they cover. A taxing authority’s fiscal year, such as July 1 to June 30, may not align with the payment due dates. For instance, a government might require payment for its fiscal year in two installments, such as in November and April. This timing difference can distort financial reporting if not managed with accrual accounting.
Without accrual, a large tax expense recorded in payment months like November and April would make profitability appear volatile. This complicates financial analysis and budgeting. Since the economic benefit of using a property occurs continuously, the related tax expense should be recognized in the same way.
While legal liability for property taxes can arise on various dates, financial accounting under Generally Accepted Accounting Principles (GAAP) favors accruing the expense monthly. This is done over the fiscal period of the taxing authority. This consistent monthly recognition provides a more accurate financial picture.
Calculating Your Monthly Property Tax Accrual
The first step in property tax accrual is calculating the monthly amount. Begin by obtaining the total annual property tax liability from the most recent tax bill. If a recent bill is not available, you can estimate based on the prior year’s tax amount, adjusting for any anticipated increases.
Once the total annual property tax is identified, divide it by twelve to determine the monthly expense. For example, if the total annual property tax is $12,000, the monthly accrual would be $1,000. This is the amount recorded each month, regardless of when the payment is due.
This process ensures that by the end of the taxing authority’s fiscal year, the full amount of the property tax expense has been recognized on financial statements. Consistently applying this calculation creates predictable financial data, which is useful for internal budgeting and for external parties like lenders who may review the statements.
The Accounting for Property Tax Accrual
Recording property tax accrual begins with a recurring monthly journal entry. Each month, you debit “Property Tax Expense” and credit “Property Tax Payable” for the calculated monthly amount, like the $1,000 from the previous example. The debit increases expenses on the income statement, impacting that month’s net income.
The credit to “Property Tax Payable” increases a liability account on the balance sheet, representing the growing obligation to the taxing authority. The balance in this liability account accumulates over time. For instance, after six months of accruing $1,000, the Property Tax Payable account will have a $6,000 balance, showing the portion of the tax bill that has been expensed but not yet paid.
When the tax payment is made, a different journal entry is recorded. This entry involves a debit to “Property Tax Payable” and a credit to “Cash.” If a $6,000 semi-annual tax payment is made, the debit to Property Tax Payable reduces the liability on the balance sheet. The corresponding credit to Cash decreases the company’s cash balance, reflecting the payment to the government.
Taxpayers using the accrual method can make an election under Internal Revenue Code Section 461 to accrue real property taxes over the period to which they relate. This election must be attached to the tax return for the first year it applies. It allows the deduction to be taken as it accrues rather than when paid, aligning the tax deduction with the accounting treatment. This choice is binding for future years unless the IRS consents to a revocation.
How Escrow Accounts Handle Property Tax
Homeowners with a mortgage often see accrual principles applied through an escrow account. With an escrow provision, the lender performs the accrual function for the borrower. This arrangement ensures funds for property taxes and homeowner’s insurance are available when due. It also protects the lender’s interest in the property by preventing tax liens.
Each month, the borrower’s mortgage payment includes principal, interest, and an additional amount equal to one-twelfth of the estimated annual property tax bill. The lender deposits this extra amount into a separate escrow account. This systematically sets aside funds throughout the year to cover the tax liability.
When property tax bills are issued, the mortgage lender pays them directly from the escrow account, so the homeowner does not have to make a lump-sum payment. This transforms a large annual expense into a manageable monthly payment. The lender periodically analyzes the escrow account to ensure the amount collected is sufficient. The monthly payment may be adjusted up or down based on changes in tax assessments.