Distinguishing maintenance and capital expenses

8 Replies

Looking at P&Ls I see a lot of stuff that is placed in capital expenses that seems like it should be in maintenance, ie above the NOI line--but I don't know completely what the industry standards are.

There are things like carpet replacements, or vague "interior repairs", exterior repairs, electrical, etc.

So, Where do we draw the line, and are there any good resources/lists that can help on this one? Do you just deal with those vague items in due diligence with an amended offer?

Thanks! Seth

I consider capital expenses as items that last a number of years and you only replace every so often. This would be big ticket items such as water heaters, furnaces, roof, etc. Repairs or maintenance to those items would probably still fall under maintenance unless its an extremely expensive one time repair. 

Carpet is a tough one. Some can make carpet last only 2 years, others make it last 5 years. I think that may depend on the market and your target renter. I've got a lower income building I'm managing and some stains in carpet doesn't seem to be a big issue for most. But, I also don't make it a habit to not replace carpet when needed. We just happen to have the one unit open for showings while we are doing some extensive repairs and fixups in the other units.

Well we need to take it from the horse's mouth here, but it is not so clear what the horse is saying!

At any rate, one of the cases involved a hotel doing extensive replacements, and it makes it look like rent-ready work that replaces like for like (ie is not not an upgrade from carpet to hardwood, etc.) is considered normal maintenance and not capitalized. It would be great if a CPA or lawyer commented, but I don't know who to tag ;).

@Seth C.

I still think CAPEX and maintenance would be above the NOI line anyway. NOI is what is left after you pay all your expenses minus the financing cost , so even if they classify it as CAPEX or maintenance it should still come off before NOI is computed .

for tax purposes they may handle each different , but that is more due to accounting 

 @Kenneth Hynes :

On MF, capital expenditures are below the line. They are not part of NOI, which is used to calculate the cap rate and thus offering price of a property (you had better not use cap rate to calculate its value to you!), but they come above before-tax cash flow.

@Seth C.

When speaking in terms of repairs vs. capital improvements, we will be referencing the IRS Final Tangible Property Regs. They provide guidance on how to determine whether an expenses is a repair or an improvement. You used to have a lot of leeway in classifying expenses as repairs, however, the Final Regs make it hard to classify expenses as repairs over capital improvements.

That said, you will need to provide a lot more information for anyone to accurately tell you one way or the other. Even with the extensive Final Regs, there are a lot of loopholes to take advantage of.

One example is flooring (regardless of whether it's carpet or hardwood). If you have 10 units, and you replace the floor in two units, you can argue that you have replaced 20% of all floors in the building. That's not a material portion of the floors in total, so you can likely deduct those expenses as repairs in the current year.

Another example would be the plumbing system (now the building is divided into Units of Property (UOPs), which essentially separates out the various systems in the building. Making a repair to a system, isn't considered a repair to the building, but a repair to the system itself, so you have to understand how that repair affects the specific system to correctly categorize the expenses as a repair or capital improvement.) If you have that same 10 unit building and you replace three toilets, two bath tubs, some piping, and a couple of vanities, it can be argued that those expenses should be capitalized and depreciated because you likely made a material improvement to the plumbing system itself.  

A last example is the air conditioning system. If you have that same 10 unit building, all with their individual HVACs, and you replace two of the HVACs, you have only replaced 20% of the building's air conditioning system. Therefore, you can argue you did not materially improve the air conditioning system and therefore can deduct the expense in the current year as a repair.

Hope this helps.

Originally posted by @Kenneth Hynes :

@Seth C.

I still think CAPEX and maintenance would be above the NOI line anyway. NOI is what is left after you pay all your expenses minus the financing cost , so even if they classify it as CAPEX or maintenance it should still come off before NOI is computed .

for tax purposes they may handle each different , but that is more due to accounting 

Neither CapEx nor debt service (financing) is an above line expense, meaning you do not use these costs to determine NOI. You determine NOI, then subtract CapEx which equals the amount of cash you have available for debt service. You then subtract financing costs to get to your cash flow.

@Kenneth Hynes ,

Thanks for the informative post! 

On a practical level I suppose I need to see the costs in any one month, and if they are below a certain threshold compared to the property size, I should perhaps bring them up because they are probably too small to qualify as capex. Otherwise there is no way to know without a due diligence discussion with the seller.

@Brandon Hall . Thanks, you were the one I meant to reference for your thorough post!

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