In property management businesses it can feel like the decision-making never ends. Small business owners dealing in property management, real estate development, or vacation rentals must consider what threshold base rents should be at, whether to use a maintenance company, if leases should be triple net (NNN) or gross, how to treat each financial transaction, and more. Some financial transactions, like monthly utility bills and budgeted contract services like landscaping, are simple. Extraordinary expenses, on the other hand, like repairing a roof, replacing an HVAC system, leasing office equipment, and other large purchases can create some confusion when recording, reconciling the balance sheet, or sending reports to the tax accountant. Whether or not certain costs should be expensed or capitalized is one of the most frequent questions property managers have. That’s why we’ve created this handy primer on capitalizing verse expensing in property management accounting. So read on to learn to learn everything you need to know about which property management cost to capitalize and which property management costs to expense now.
What are the basic differences between capitalizing and expensing?
Every dollar that comes into or out of an organization is recorded in the business’s financial records. When money comes out of the business bank account for any reason, the cost must be recorded to indicate which type of expense it is. Some payments will reduce liability accounts, like the mortgage, or cancel out open payable items, like returning security deposits, but most payments made by property management companies will need to be expensed or capitalized. The Internal Revenue Service (IRS) and Generally Accepted Accounting Principles (GAAP) dictate the treatment of some costs, but for others, the treatment is up to the business owner and tax preparer.
The most significant difference to most property owners is the effect capitalizing or expensing costs will have on their pre-tax profit, taxes, and the value of their total assets. Transactions that are recorded as expenses will reduce the business’s annual net income by their full amount which will decrease the tax base and have no impact on the total value of assets. Transactions that are capitalized, or capital expenditures, are depreciated over time to reduce net income over several years and therefore have less of an impact on taxes in the first year. As capital expenditures are recorded as fixed assets on the balance sheet, they increase the total net worth of a business or business owner, at least until they are fully depreciated. Read on for more details.
A closer look at capital expenditures
Capital expenditures describe purchases that are intended to be used over an extended amount of time and increase the fair market value of the real estate. Items that are capitalized are not included on the business’s income statement, or profit and loss (P&L) reports. Those transactions are listed on the company’s balance sheet, increasing the total value of assets. The assets are depreciated over time, typically determined by the useful life of the asset. Depreciating the cost means that a portion of the initial cost is listed as depreciation expense and listed on the income statement each year that the asset is still in service. Depreciation expense is then subtracted from the total income, along with operating expenses, to calculate Net Income, profit, and taxable liability.
Capital expenditures (CapEx) are typically items that will be used in the course of business for more than one year. They can be ‘tangible’ and ‘intangible’. Tangible capital expenditures are those purchases and repairs that are beyond the normal scope of operations for the property. Intangible CapEx items are expenses incurred that increase the value of the business but don’t involve physical improvements. Some examples of tangible and intangible capital expenses include:
- Roof replacements
- Company vehicles
- Office equipment, including computer hardware and software
- Parking lot repaving
- New carpet
- Maintenance equipment, like a floor buffer, power washer, or landscaping machinery
- Exterior fencing
- Monument signs
- HVAC system replacement, and some repairs or partial replacements like the compressor
- Elevator replacement or repair
- Leasing commissions paid to brokers for new leases
- Legal fees incurred during real estate purchase or development due diligence
- Loan costs for placing debt on the property
In short – capitalizing purchases increases the value and total assets of a company, while slowly reducing profit via depreciation over the life of the asset, which spreads the tax impact out over multiple years.
A closer look at operating expenses
Typically, items that need to be expensed are costs that benefit daily operations. Operating expenses are summarized on the business’s income statement and used to calculate Net Income (NI), Net Operating Income (NOI), and profit. Many business owners want to have the freedom to capitalize any large ticket transaction, like a major roof repair or the costs to repair a busted sprinkler system. Unfortunately, categorizing purchases as an operating expense (OpEx) or CapEx is determined by more factors than just cost.
Purchases made that are intended to be used by the business in the current accounting period should be recorded as expenses. Repairs to the property that does not increase, but simply restore, the value of the asset should also be expensed. Some examples of operating expenses common to property management include:
- Real Estate taxes
- Employee salaries
- Monthly utility costs
- HVAC coil replacement
- Repairing a section of the roof
- Property management and asset management fees
- Parking lot sealing and striping
- Advertising and marketing costs
- Legal fees under $1,000, like eviction costs
- Interest charges on debt payments
In short – expensing purchases allows the business owner to reduce their taxable income by the total cost in the same year the money was spent.
What does the IRS say about capitalizing vs. expensing?
According to the Internal Revenue Service (IRS), the following general conditions must be met for an item to be capitalized:
- Necessary cost to correct a design flaw
- Costs to expand, or increase the physical size of an asset
- Costs to increase capacity or productivity
- Costs necessary to rebuild an asset that has exhausted its natural useful life
- Costs to replace a major component or structural part of the property
- Costs spent to adapt a land or building for a new business use
Practically applied, capital expenditures improve the operating condition of a property by increasing the useful life, fair market value, or capacity of the land or building. Expenses, on the other hand, are costs necessary to keep the property in proper operating condition or restore it to its previous condition.
How to tell between an expense and CapEx
In property management it can be difficult to determine whether a large purchase or repair can be a capital expenditure. If the item improves the land or building, thus increasing its value, it can be a capital expense. If the repair or purchase is simply getting the asset back to working order, it should be expensed. For some large ticket items, the business owner can make decisions regarding which items to capitalize based on their short-term and long-term financial goals. For example, if an entrepreneur is interested in marketing the property to sell in the next few years, they will favor capital expenditures that increase the value of their property. However, if an owner plans to hold the property long term for the benefit of collecting passive rental income, expensing items will result in more aggressive tax deductions (thus increasing cash flow in the short-term.) A Certified Public Accountant (CPA) that prepares the federal income tax returns for the business is an excellent resource on the latest guidelines regarding capitalizing versus expensing transactions in property management. (Speaking of resources, check out this great article to learn the basics of property management accounting.)
- Capital expenditures are added to the company’s balance sheet as an asset.
- The costs of capital expenditures are depreciated over time.
- Capitalized expenses are costs incurred to improve the property.
- Expensed purchases are added to the company’s income statement as an operating expense.
- Expenses reduce net income, taxable liability, and profit in the year that they were purchased.
- Operating expenses are costs incurred to maintain the property.
Hopefully you’re now a bit of an expert on capitalizing verse expensing in property management accounting. Remember, if you’re wondering, “what real estate costs should I capitalize?”, consider what your short and long terms goals are, and, of course, what the rules are. (And, feel free to come back to our primer on real estate capitalization rules as well…)
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