Property owners likely agree that distinguishing between investment properties and owner-occupied properties is important for proper accounting and reporting.
By understanding the key differences in accounting for these two types of properties, you can correctly apply the relevant standards and principles.
In this post, we will compare and contrast the accounting and reporting for investment properties versus owner-occupied properties. You will learn the precise definitions, accounting framework options, tax implications, changes in use procedures, and disclosure requirements for each.
Introduction to Property Accounting Variants
Investment properties and owner-occupied properties have key differences in how they are accounted for, valued, and reported on financial statements. This section will overview these variants in property accounting.
Defining Investment Properties vs Owner-Occupied Properties
Investment properties are properties held to earn rental income or for capital appreciation. They are not used in the production or supply of goods and services by the company that owns them. Some examples are rental apartments, commercial buildings leased to tenants, vacant land held for future development, etc.
In contrast, owner-occupied properties are properties held for use in the production or supply of goods and services by the company that owns them, or for administrative purposes. Examples include office buildings, factories, warehouses, retail stores occupied by the owner, etc.
A key difference is that investment properties are held to generate income from external parties, while owner-occupied properties generate income internally as part of a company's operations.
Overview of Relevant Accounting Standards
Accounting standards like IAS 40 and IFRS 13 dictate specific valuation and reporting rules for investment properties that differ from other assets:
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IAS 40 allows companies to choose either the fair value or cost model to value investment property. This provides more flexibility compared to valuing owner-occupied property only at depreciated cost.
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Investment properties valued under the fair value model must be revalued to fair market value each reporting period, with gains/losses recognized in net income. This differs from typical depreciation treatment for property, plant and equipment (PPE).
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Additional disclosures are required for investment properties around the valuation model chosen, restrictions on saleability, contractual obligations, etc.
So in summary, investment property accounting has some unique aspects that set it apart from accounting for owner-occupied properties. The next sections will explore the valuation and reporting differences in more detail.
What is the difference between owner-occupied and investment?
The main difference between owner-occupied and investment properties comes down to the intended use and tax treatment:
Owner-Occupied Property:
- A property you intend to live in as your primary residence
- Subject to capital gains tax exemption on sale up to $250k (or $500k for married couples)
Investment Property:
- A property you intend to generate rental income from
- Subject to capital gains tax when sold
- Rental income and expenses reported on Schedule E
Both types of properties can be depreciated, but investment properties see larger depreciation deductions. Investment properties also have more flexibility with financing options.
When accounting for investment properties, they must be reported at fair value under IFRS rules. This means the value is adjusted each year based on market conditions rather than historical cost. With owner-occupied residences accounted for at historical cost less depreciation.
So in summary:
- Owner-occupied - primary residence, capital gains tax exemption
- Investment - generate rental income, subject to capital gains tax, more tax deductions
The accounting and tax treatment differs significantly based on the intended use of the property.
How is an investment property distinguished from owner-occupied property?
Owner-occupied property is property held (by the owner or by the lessee as a right-of-use asset) for use in the production or supply of goods or services or for administrative purposes. Investment property is held to earn rentals or for capital appreciation or both.
Some key differences between investment property and owner-occupied property include:
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Purpose: Investment property is held to generate rental income or capital appreciation, while owner-occupied property is held for use in business operations.
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Accounting treatment: Investment properties are accounted for differently than owner-occupied properties under accounting standards like IFRS and US GAAP. Key differences relate to measurement models, depreciation, disclosures, etc.
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Valuation: Investment properties are valued based on fair value models reflecting market conditions. Owner-occupied properties follow a cost model based on historical costs less depreciation.
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Tax treatment: The tax treatment may differ for revenues, expenses, depreciation, and gains/losses between investment properties and owner-occupied properties in many tax jurisdictions.
In summary, the main distinction lies in the purpose of holding the property. Owner-occupied properties are held for internal use to produce goods/services. Investment properties are held to generate rental income streams or capital appreciation through an external market. This leads to important differences in accounting and tax treatments per relevant standards and regulations.
What is the difference between PPE and IP?
An investment property is a property held for the purpose of earning rentals or capital appreciation or both. It differs from property, plant and equipment (PPE) in that the PPE is held for producing the company's goods and services.
Here are some key differences between investment property and PPE:
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Purpose: Investment property is held to earn rentals or for capital appreciation. PPE is held to produce goods or provide services.
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Accounting treatment: Investment properties are accounted for using either the fair value or cost model under IAS 40. PPE is accounted for at cost less depreciation and impairment.
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Revaluation: The fair value of investment properties must be revalued each reporting period with changes flowing through net income. PPE is not revalued.
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Depreciation: Investment properties are not depreciated under the fair value model. PPE is systematically depreciated over its useful life.
In summary, the main difference lies in the purpose for holding the asset. Investment properties generate cash flows largely independent of the other assets held by an entity. Hence they are accounted for differently than PPE used directly in operations.
What is the difference between personal property and investment property?
The key difference between personal property and investment property lies in its intended use.
Personal property refers to a home that you live in as your primary residence. It is where you sleep, raise your family, and generally conduct your daily living activities. Any property used as your main home would be considered personal property.
On the other hand, investment property is real estate that you purchase specifically to generate rental income, appreciate in value over time, or both. While an investment property may be fully capable of serving as a personal residence, its main purpose is to produce financial returns rather than provide owner housing.
Some other key differences:
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Tax treatment - There are different tax implications for personal use property versus investment assets. For example, capital gains tax often does not apply to the sale of a primary home up to a certain amount. However, gains on investment properties are generally taxable.
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Financing - It is usually easier to qualify for favorable mortgage rates on a primary home compared to a rental or investment property. Down payment requirements and lending standards also tend to be more stringent for investment real estate.
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Insurance - Personal use property can often be covered under a standard homeowner's insurance policy. Investment properties usually require a separate policy with different coverage considerations.
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Expenses - Costs associated with personal property are not tax deductible, while many expenses for rental properties can be deducted against rental income.
So in summary, while personal and investment properties may share similar physical characteristics, their intended use and financial considerations differ quite significantly. Understanding these key differences is important for real estate investors.
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Investment Property Accounting Frameworks
Investment properties can be accounted for using either the fair value model or the cost model under IAS 40. The key differences between these approaches are:
Investment Property Fair Value Model vs Cost Model
The fair value model requires investment properties to be measured at fair value at each reporting date, with changes in fair value recognized in profit or loss. This provides more relevant information to users, but can introduce volatility.
The cost model instead requires investment properties to be measured at depreciated cost less impairment losses. While this is more stable, it does not reflect current market values.
Revaluation of Investment Property Journal Entries
Under the fair value model, upward revaluations are recorded with a credit to revaluation surplus and a debit to the investment property account:
Dr Investment Property X
Cr Revaluation Surplus X
Downward revaluations are recorded by first reducing any previously recognized revaluation surplus, with any excess booked against profit or loss:
Dr Revaluation Surplus X
Dr Profit or Loss X
Cr Investment Property X
The cost model instead records depreciation expense and impairment losses against profit or loss over time.
IAS 40 Investment Property: Measurement Models Comparison
The fair value model is preferable when investment properties have volatile or rising values, as it reflects current worth. However, it can introduce earnings volatility. The cost model provides more stable earnings, but does not indicate market value. Management should weigh these factors when selecting an appropriate model.
Overall, IAS 40 provides options for reporting investment properties depending on a company's specific circumstances and user information needs. Both models have tradeoffs that should be considered.
Tax Implications in Property Accounting
This section will discuss some of the unique tax implications that investment property accounting can create under different measurement models.
Capital Gains Tax: Fair Value Model Implications
The fair value model requires investment properties to be measured at fair value each reporting period, with changes in fair value recognized in profit or loss. This can create larger capital gains taxes when the property is eventually sold, compared to the cost model.
For example, if an investment property was purchased for $1 million and later sold for $2 million, the capital gain would be $1 million. However, if the fair value of the property rose to $1.5 million in between the purchase and sale dates, that $500,000 unrealized gain would be taxable even before the property sale.
So while the fair value model provides more relevant information to investors, it can also accelerate capital gains taxes owed on appreciating investment property assets. Proper tax planning is essential when using this accounting method.
Cost Model and Depreciation Recapture Tax
Under the cost model, investment properties are carried at historical cost less accumulated depreciation and impairment losses. This allows depreciation deductions over the useful life of the property, providing a tax shield benefit.
However, upon sale of the property, depreciation previously claimed must usually be "recaptured" at ordinary income tax rates rather than lower capital gains rates. This depreciation recapture can result in higher overall taxes compared to the taxes owed if the property was not depreciated for accounting purposes.
So the cost model delays capital gains taxes but leads to larger depreciation recapture taxes in the future. Companies should model the tax cash flow impact of each method to determine the optimal approach aligned with their investment strategy and holding period expectations.
Handling Changes in Property Use
In some cases, real estate may shift from being owner-occupied to an investment property (or vice-versa) so guidance on handling these classification transitions will be provided.
From Owner-Occupied to Investment Property: Accounting Shifts
When a property transitions from being owner-occupied to an investment property, the accounting treatment changes. Specifically:
- The property is remeasured to fair value at the date of change in use. Any gain or loss arising is recognized in profit or loss to the extent the gain reverses previous impairment losses.
- The revalued amount becomes the deemed cost under the fair value model going forward.
- Depreciation ceases on the property.
- Rental income and operating expenses are recognized in profit or loss.
- Changes in fair value are recognized in profit or loss.
For example, if a property with a carrying value of $800,000 is reclassified to investment property and has a fair value of $1 million at that date, the entity would recognize a gain of $200,000 in profit or loss. The property's new carrying amount would be $1 million and subsequent changes in fair value would be recorded in profit or loss rather than equity under the previous revaluation model.
Investment Property to Owner-Occupied: Reversing the Process
When an investment property becomes owner-occupied, the accounting treatment reverses in the following ways:
- The property is remeasured to its fair value at the date of change in use.
- This fair value becomes the deemed cost under the cost model going forward.
- Depreciation begins on the property.
- Rental income and operating expenses cease being recognized.
- Subsequent changes in fair value are not recorded.
For example, if an investment property with a fair value of $1.2 million becomes owner-occupied, its new carrying amount would be $1.2 million. This becomes the cost basis for calculating depreciation expense going forward rather than recording changes in fair value.
Handling transitions between investment properties and owner-occupied properties requires reassessing classification, valuation models, and specific accounting treatments. But following the above guidance helps ensure accurate financial reporting.
Investment Property vs PPE: Disclosure and Reporting
Investment properties have specific disclosure and reporting requirements under IFRS that differ from other asset classes like property, plant and equipment (PPE).
Investment Property IFRS Disclosure on the Balance Sheet
Investment properties must be presented as a separate line item on the face of the balance sheet. Related disclosures in the footnotes should include:
- The fair value measurement method used (e.g. discounted cash flows, market comparables) and key assumptions.
- Restrictions on ability to sell the property or receive rental income.
- Contractual obligations to purchase, construct, develop or repair investment property.
- A reconciliation of the carrying amount from the beginning to end of the period showing additions, disposals, net fair value gains/losses, transfers in/out of the category etc.
Reporting Rental Income and Expenses in the Income Statement
The income statement should reflect:
- Rental income from investment properties, disclosed separately from revenue streams like goods sold or services rendered.
- Direct operating expenses like repairs, maintenance, property taxes and insurance.
- Fair value gains or losses as a separate line item.
- Depreciation is not recorded on investment properties measured at fair value.
In summary, investment properties have tailored disclosure rules for balance sheet presentation and income statement treatment compared to assets in other categories like PPE.
Concluding Investment and Owner-Occupied Property Accounting
In closing, we will revisit the major differences between accounting for investment properties versus owner-occupied properties and summarize some best practices in this area.
Recap of Investment Property Fair Value and Cost Models
The key differences between the fair value model and the cost model for accounting for investment properties include:
- The fair value model records investment properties at their fair market value on the balance sheet, while the cost model records them at depreciated cost.
- The fair value model recognizes changes in fair value as gains/losses in net income, while the cost model recognizes depreciation expense.
- The fair value model provides more relevant information to investors on an investment property's current value, while the cost model shows historical cost less depreciation.
In general, the fair value model is preferred for investment properties under IFRS because it better reflects current values. However, the cost model may be easier to implement operationally.
Final Considerations for Property Accountants
Some key issues property accountants should consider include:
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Tax Implications: Using the fair value model can create taxable gains, while the cost model generally aligns more closely with tax depreciation. Complex rules exist around deferred taxes for investment properties.
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Disclosure Requirements: Detailed disclosures around valuation techniques, key assumptions, reconciliation of changes, etc. are required under IFRS for investment properties at fair value.
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Classification Issues: Care must be taken to appropriately classify properties between investment, inventory, fixed assets, assets held for sale, and determine proper accounting treatment.
In summary, accounting for investment properties can be complex, especially under the fair value model. Paying close attention to valuation, disclosure, classification, and impacts on tax and financial reporting is key.
