Accounting Differences Between Arizona Rent Tax and Sales Tax

Background

Earlier this year, the financials for one of my Arizona portfolio's office properties caught my attention. We recently changed management companies, so I expected certain liberties to be taken in restructuring statement presentation. However, the differences were large enough to prevent us from being able to reconcile what we track for the property's revenue and receivables against what the management company presented. We were using the same convention for revenue recognition, but remained a small percentage apart. The clue was in an account that coincidentally appeared, Sales Tax Payable.

From seeing this account, it was immediately clear what had happened. The management company was treating Arizona transaction privilege tax as sales tax would be treated. Sales tax is collected by the vendor at the point of sale on behalf of a taxing authority, and the remitted at some future date by the vendor to the authority.

A point of sale cash transaction for a sale worth $100 with sales tax of 10% would have the following journal entries:

The vendor would later remit to the tax authority:

Here, we sold something worth $100 in a jurisdiction with a 10% sales tax. We collected the tax at point of sale, and then paid the tax authority at a later date. Seems reasonable. In Arizona for tax collected on rent, this is incorrect.

Where Does the Sales Tax Idea Come From?

Many commercial office leases in the state of Arizona include amount due to landlord by tenant for Transaction Privilege Tax (TPT). The landlord also has an obligation to pay TPT on any amounts collected for rent. So, we're collect rent tax and we're paying rent tax. That seems a bit like the above sales tax example. The difference is, the landlord doesn't have to charge the tenant for rent tax and it's not an obligation of the tenant. This worked it's way into commercial office leases as means of passing along a landlord cost to the tenant. And fair enough, we have to make a living too. But just because landlords don't wish to pay this expense, it doesn't mean rent tax now becomes a tenant obligation to the tax authority.

Arizona Rent Tax is not Sales Tax

Arizona rent tax isn't sales tax in the way we commonly use the term. The term 'sales tax' is often used in circumstances where upon a sale, a tax obligation is created belonging to the purchaser/customer, not the vendor. But the vendor collects the sales tax and pays it, doesn't that mean it's the vendors obligation? It's often the vendor's performance obligation to pay the tax, but it's not their financial burden. Tax authorities tend to require a seller to collect sales tax for simplicity. But it's the purchaser's obligation, hence why you're able to deduct it on your tax return.

Arizona Rent Tax, also known as TPT is not this. It doesn't matter if you collect this amount from your tenants or not. It is still owed to the Arizona Department of Revenue (ADOR).

On the Arizona Department of Revenue's website, it mentions this reality out of the gate (as of November 20, 2023):

Although commonly referred to as a sales tax, the Arizona transaction privilege tax (TPT) is actually a tax on a vendor for the privilege of doing business in the state. Various business activities are subject to transaction privilege tax and must be licensed.

Why the Distinction Matters

Let's say, you're still somehow paying the correct amount. That is, somehow the amounts you're collecting equate to the amounts owed to ADOR. First and most importantly, your books are incorrect even though you're (potentially) not out of compliance with your tax authority. And that's no small problem. If you're managing money for another party, you have an obligation to present your financials fairly and accurately. Using a sales tax-like approach in treatment of TPT, is fundamentally wrong. Even if you're not a fund manager and the property is wholly owned by you, you're still using financials that aren't telling the story as well as they could be. The decision usefulness has been reduced. In financial reported, precision matters. Otherwise, what's the point to begin with? Shove those receipts in the drawer and let your tax shop figure out your returns at the end of the cycle.

Your Tax Payments are (Likely) Still Wrong

It's possible you're paying the correct amounts using a sales tax-like approach. But, the chances that the amounts you collect differ from the amounts you should be paying is likely. There are many ways this could occur and I'll touch on a few:

Cash vs. Accrual

Your tax payments are going to be based upon the actual collections made in the relevant period. You can often select the period measure: month, quarter, etc. But the convention will be cash. And that's a good thing. We don't want to pay tax on amounts uncollected.

On the other hand, your revenues will likely be accrual. Much of real estate accounting can be done a cash basis, but revenue is not one of those items. If you're sending out invoices, there should be a corresponding journal entry that's representative of the sum of those invoices. Otherwise, knowing what's outstanding wouldn't be an easy task to handle.

Each period will begin with a revenue accrual similar to:

Then, as your payments roll in, you'll reduce your receivable and increase cash.

But what if your collections don't all occur in the given period? Then the amount you recorded as Rent Tax Income will differ from the amount ADOR expects you to pay. Remember, tax is determined on a cash basis. Unless your receivables start at zero and end at zero for each period, the difference between cash and accrual accounting will cause a discrepancy.

Also, the tax you pay in the current period is always for activity in the preceding period (unless we're talking about estimated tax payments, which is an unrelated concept). So, we'll always be outside of the period when the payment is made. But, you say, this is why we have the Sales Tax Payable account. With this account, the difference between what tax we recognize, what tax we collect, and what tax we pay is driven through the liability account and our books remain in balance. And fair enough, but does the amount recognized in your income equate to your obligation?

Amounts Collected vs Amounts Owed

Using the previous example with entries in the amounts $110, $10, $100 for a receivable, rent tax income, and basic rental respectively, let's look at what we actually owe should we be operating in a jurisdiction with a 10% tax rate. Assume that our receivable was completely settled in the current period. We have good tenants who pay on time, and we recorded cash receipts of $110. Then, we should pay the $10 of rent tax to ADOR? Wrong. We're paying tax on collections and there aren't a lot of exceptions to this. One of the only exceptions to paying tax on what you're paid by tenants is security deposits. And even then, there are stipulations to be followed. It can be safely assumed that if a tenant paid you for anything other than a security deposit, you're paying TPT.

Instead of paying the $10 collected as reimbursement for 10% TPT to ADOR, you're paying the percentage on the entire amount of $110. That calculation leaves you with a tax obligation of $11. If you weren't tracking TPT separately, and instead opting for the Sales Tax Payable strategy mentioned above, your liability account would be growing by $1 each period from underpayment.

Not Every Tenant Pays

What if a tenant on the rent roll doesn't have a lease that obligates them to pay the landlord a TPT reimbursement? The reimbursement is a very common lease item, but it's not ubiquitous. Large, commercial tenants tend to object to this charge.

Another tenant I know doesn't pay TPT is the Federal Government. I've inherited many leases with government tenants from acquisitions. Not one has ever had a reimbursement for TPT. I've tried to insert the reimbursement into new deals as well and was told by gov't counsel this wouldn't fly. I've also had gov't representatives tell me not to worry because the Federal Government is tax exempt and I don't need to worry about paying TPT for rents collected from them. I've spoken to multiple property managers who've reiterated this. But is it the case that you don't need to pay TPT on rent received from the government? Let's see what Arizona Administrative Code R15-5-1605. Rental to Government Agencies has to say on the subject:

Gross receipts from the rental of real property to the United States Government, state of Arizona, or any other government agency shall be taxable under the commercial lease classification unless otherwise exempt.

Unless you've been delivered a document by your tenant with the ADOR's seal on it giving you exemption, plan on paying TPT tax on amounts collected. Even if it's from the Government. And you cant trust your tenants to be informed on the topic either. Even if they're from the Government. They can be misinformed and it's your fault if they are and you trusted them. It's your responsibility to get this right so do the research.

Perhaps every other tenant besides one is paying the reimbursement charge but one, now the revenue amount can no longer be relied to get you to (roughly) the right spot. Leases come in many shapes and sizes, just because every lease you've seen thus far has included this reimbursement, doesn't mean that the convention is gospel.

TPT Done Right

We've explored a handful of things not to do when handling TPT. Now let's look at how it can be done correctly. I'll start by demonstrating the following activity through journal entries and then offering an explanation of events:

• Accrue revenues of $100 in basic rental and $10 of rent tax income in the current period,
• Accrue a liability for rent tax payable on $80 of collections from the previous period using a 10% tax rate,
• Record collections of $90 in the current period, and
• Record our payment to the tax authority in the current period.

First, we together accrual our receivable for the current period and our tax payable for collections made in the prior period:

Then, we record our collections as they roll in:

And finally, we pay our outstanding tax liability:

Here, we recorded our revenue, accrued a tax of 10% of last period's $80 collections, collected a bit of rent in the current period, and finally paid our outstanding balance owed to the tax collector. When mapped out, the above transactions appear agonizingly rudimentary. And for the most part, it's pretty basic. Just the same, it's something that's done wrong time and time again by people I wouldn't label as stupid (but perhaps lazy).

Final Thoughts

My point with this article isn't that handling TPT is complicated, but instead the opposite. There isn't anything above that a first-year accounting student, barely exposed to concepts of financial accounts, journal entries, and a 'T-Account.' Yet still, I see educated accountants routinely get this wrong and defend their reasoning.

I see this as laziness, first and foremost. Rather than react to a transaction superficially, take the time to consider what the information is telling you. Is this a benefit/obligation in the current/future period? Well rent tax income is written in leases and not the tax code so that sounds like an obligation of the tenant and a benefit of a landlord. The tax code shows that landlords must pay tax on collections. That sounds like an obligation of the landlord. Evaluate the nature of the event you're intending to record instead of impulsively applying a judgment based on the event seeming to be similar to something else. Just because it sounds like sales taxes, looks like sales tax, doesn't mean it is.

And your job doesn't stop there. Be careful to consider the specific nature of the tenant, and whether there's exemption or not. The burden is on the landlord to make the correct determination. Don't be lazy.