No one in the real estate industry wants to undergo a real estate audit, but an audit is a potential part of operating a real estate business. Taking the proper measures before audit time will help eliminate risk and ensure compliance in each real estate transaction. However, if and when the time comes, it's good to have an understanding of what a real estate audit is and how it works.
What is a real estate audit?
An audit, which is most commonly ordered by the Internal Revenue Service (IRS) or other third-party agency, is the process of reviewing a company, firm, or individual's finances to ensure its financial statements are being maintained and reported accurately. Unlike an IRS audit, which addresses an individual or company's tax filings, a real estate audit looks at the overall financial and operational standing of a company, including its compliance and record-keeping for each real estate asset and transaction.
The ultimate goal of the audit is to verify the validity of all income, losses, and transactions for the company in the given audit period. This includes compliance with state and local regulations for each asset or the management of the assets and compliance with payments to any lenders or interested parties.
In real estate, it's fairly common for an audit to be conducted routinely as a way to implement risk management tactics to assess compliance within a real estate company, but there are events in which an audit is required, such as pending litigation.
How a real estate audit works
An auditor will be assigned to oversee the audit process, initially submitting an audit checklist for the real estate company to review. This checklist will outline exactly what documents are required for the review process, which could include:
- Purchase or sale contracts for all real estate activity.
- Funding agreements with any private investors, lenders, or joint ventures.
- Financial accounting records, including bank statements, tax return, profit and loss statements, and more.
- Records for any escrow funds, earnest money, or trust funds received or held.
- Property management reports, including leases, repairs, or other property-related expenses.
- Property valuations and condition or impairment reports.
- Corporation minutes, annual meeting notes, or other entity-related documentation.
Most audits are done for a designated audit period, which could be one or more fiscal years. Once the necessary documents are provided, the auditor will review the files and submit an audit report, identifying potential weaknesses, long-term compliance issues, or critical issues that need to be rectified immediately. From there, any work to rectify issues discovered in the audit should be documented and reported carefully, showing the effort and steps to mitigate the issue at hand.
The Millionacres bottom line
It's far more common for a real estate investor to undergo a routine audit than have to undergo an audit for other purposes. Large corporations, including real estate investment trusts (REITs), are subject to routine real estate audits each year. Completing an audit proactively helps eliminate the hassle, stress, and risk of what could be uncovered during a required one.
Several companies offer routine audit services specific to real estate and can help assign roles to the right employee or department, such as a bookkeeper, CPA, or attorney. Most small-scale investors don't have to worry about a real estate audit, but it's still a good idea to run your business like a big corporation. Following the same documentation and record-keeping guidelines ensures you're staying compliant and reducing your risk and liability as a real estate investor.