Accounting: CapEx or Expense?

Accurate financial reporting is the backbone of smart real estate investing—and one of the most common areas of confusion is the distinction between capital improvements and expensed repairs. Misclassifying these items doesn’t just distort your property’s financial performance; it can also lead to compliance issues and lost tax benefits.

Understanding how to correctly categorize property expenses is essential for maintaining accurate books, optimizing tax deductions, and presenting clear financials to investors or lenders. Let’s break down the key differences between capital improvements and expensed repairs—and why it matters.

What Are Expensed Repairs?

Repairs are costs incurred to maintain the current condition of a property or restore it to its original, functional state. These are typically routine, short-term fixes that do not materially increase the property’s value, extend its useful life, or adapt it to a new use.

Examples of Expensed Repairs:

• Fixing a leaky faucet
• Patching drywall
• Replacing broken window panes
• Minor HVAC servicing
• Repainting a few interior walls

Accounting Treatment:

These costs are fully deductible in the year incurred and appear on the income statement as an operating expense. They reduce taxable income in the current period and are not added to the property’s basis.

What Are Capital Improvements?

Capital improvements, by contrast, are expenditures that add value, prolong the life, or adapt the property to a different use. These are larger investments that typically have a benefit extending beyond one year.

Examples of Capital Improvements:

• Installing a new roof
• Renovating kitchens or bathrooms
• Upgrading plumbing or electrical systems
• Adding a new HVAC system
• Building a deck or adding square footage
• Replacing all flooring in a unit

Accounting Treatment:

Capital improvements must be capitalized, meaning they are recorded as an asset on the balance sheet and depreciated over time based on IRS guidelines (e.g., 27.5 years for residential property improvements and 39 years for commercial property improvements).

Why the Distinction Matters

1. Tax Implications:
   • Expensed repairs offer immediate tax relief, while capital improvements provide long-term depreciation benefits.
   • Misclassifying a capital improvement as a repair can result in underpayment of taxes and IRS penalties.
   • Misclassifying a repair as a capital improvement can defer deductions unnecessarily, hurting current cash flow.
2. Investor Reporting:
   • Investors rely on accurate financials to assess asset performance.
   • Inflating operating expenses by misclassifying improvements can distort key metrics like net operating income (NOI) and cash-on-cash return.
3. Loan Covenants and Underwriting:
   • Lenders scrutinize financial statements when assessing loan eligibility.
   • Proper expense classification ensures clarity in operating performance and reserves.

IRS Guidance and the “BAR” Test

The IRS uses the “BAR” test to help determine if a cost should be capitalized:

• B – Betterment: Does the expense improve the property’s condition beyond its original state?
• A – Adaptation: Does the change modify the property for a new or different use?
• R – Restoration: Does the work restore a major component or structural part?

If the answer to any of these is yes, the cost is likely a capital improvement.

Safe Harbors and Exceptions

In 2014, the IRS issued the Tangible Property Regulations, which introduced safe harbors for small taxpayers and routine maintenance:

• De Minimis Safe Harbor: Businesses can expense purchases under a certain threshold (e.g., $2,500 per invoice/item if no audited financials). If financials are audited, the de minimis safe harbor is $5,000 per invoice/item.
• Routine Maintenance Safe Harbor: If the maintenance is expected to be performed more than once over a 10-year period, it may be expensed.
• Small Taxpayer Safe Harbor: For taxpayers with buildings under $1M and gross receipts under $10M, certain repairs may be expensed up to 2% of the building’s unadjusted basis.

These provisions can significantly affect your ability to deduct costs upfront—making it essential to work with a knowledgeable CPA.

Final Thoughts

For real estate investors, getting the classification of property expenses right is more than an accounting technicality—it directly impacts tax strategy, cash flow, and decision-making. While repairs maintain your asset, improvements enhance it, and each should be recorded accordingly.

If you’re unsure whether a recent property expense qualifies as a repair or a capital improvement, consulting with a real estate-focused CPA is the best way to avoid missteps. Proper classification ensures compliance, maximizes deductions, and helps you present the most accurate picture of your property’s performance.