For some residential investors, capital expenditure terminology — CapEx for short — is unfamiliar. Capital expenditure reserves are common in the commercial real estate sector but lesser known in the residential real estate space.
A capital expenditure is something you can capitalize over a certain time period. It adds to or upgrades a property’s physical assets. It is typically a one-time major expense.
Examples of capital expenditures include a new roof, appliance or flooring. A capital expenditure could also include installing a new heating and air conditioning system or doing a major overhaul of an existing HVAC system. The same goes for extensive new plumbing or major electrical work.
If you are painting multiple properties, that could be classified as a capital expenditure, but routine painting upon move-out is just that, routine. You won’t be able to tap your capital expenditure reserve to pay for run-of-the mill maintenance.
MAINTENANCE AND REPAIRS
Repairs such as move-out painting, touch-up painting, or patching a wall or floor fall into the routine category. The cost of routine maintenance is typically covered by an investor’s annual operating budget, not from the capital expenditure reserve.
The easiest way to identify routine maintenance is to ask yourself if the repair is something that tends to be reoccurring. Examples include repair of existing appliances, cleaning the carpets or patching a worn section of flooring.
Some repairs could be conceivably paid for from either the capital expenditure fund or the operating fund. Look at whether the expense is “major” to determine whether it qualifies to be paid for from capital expenditure reserves.
For example, if you need to replace multiple sinks or toilets, that would come from the CapEx reserves, but if you only need to replace one sink or one toilet, that would come out of your annual operating budget. If you need to replace one light fixture, expect to pay for that from your operating budget. If you need to replace multiple light fixtures, the expense could come from the CapEx fund.
The following table summarizes many of the factual considerations used by the IRS. These factors, although not exhaustive, should be considered in your analysis to distinguish between capital expenditures and deductible repairs:
|Improvements that “put” property in a better operating condition||Improvements that “keep” property in efficient operating condition|
|Restores the property to a “like new” condition||Restores the property to its previous condition|
|Addition of new or replacement components or material sub-components to property||Protects the underlying property through routine maintenance|
|Addition of upgrades or modifications to property||Incidental repair to property|
|Enhances the value of the property in the nature of a betterment|
|Extends the useful life of the property|
|Improves the efficiency of the property|
|Improves the quality of the property|
|Increases the strength of the property|
|Increases the capacity of the property|
|Ameliorates a material condition or defect|
|Adapts the property to a new use|
Hopefully these examples give investors a clear idea of the difference between capital expenditures and routine maintenance.