Capitalizing Verse Expensing in Property Management

A row of toy houses, symbolic of our discussion of capitalizing verse expensing in property management.

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
  • Patents

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.

A hand holding keys, symbolic of discussing capitalizing expenses in property management.
Capitalizing verse expensing in property management can be confusing. Hopefully these tips on when to expense property management costs will help. Read on!

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.)

Key Takeaways

  • 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…)

Want to learn some more great stuff? Check out our article on hiring employees in California, or this great article on starting a business in Orange County.

Who are we? We’re My OC Bookkeeper. We provide businesses all over Southern California with bookkeeping and business consulting services. We especially love working with property managers and other real estate professionals (don’t tell anyone), but work with all kinds of great companies. Where you’re in Irvine, Newport Beach, or anywhere else in Southern California, we’re standing by to help. Reach out today and let’s do great things together.

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Property Management Accounting Basics

A lovely apartment building with several decks intended to represent property management and property management accounting.

An Introduction to Property Management Accounting

Real Estate and Property Management are strong stable markets. Purchasing investment properties or managing those properties for others is a smart move in today’s economy. Making a move towards property management comes with infinite questions about how to handle the transactions, though. All businesses rely on an accounting function to keep them afloat, but property accounting requires specific skills to drive a successful property management venture.

What is Property Accounting?

Property management accounting is essentially landlord accounting. Real Estate structures that contain leased spaces include commercial retail buildings, office buildings, industrial spaces, and residential properties. Property accounting records the transactions that deal with the revenues earned from rents and all the expenses that go into running the property.

Property management accounting is unique from other types of accounting because property management often means multiple properties, so the accounting must be done separately for each entity. Each property requires that accounts be kept for the property itself and for each of its tenants. This means multiple charts of accounts, bank accounts, and financial reports. Investors or small companies that have one or a few buildings may not start out with separate companies for each, but growth will mean setting up multiple legal entities.

Accounting for properties that generate income can be overwhelming, so it is best to break the cycle into steps, or phases. While the demands of properly accounting depend on the specifics of the business, there are four basic phases to the accounting cycle. A property management cycle typically occurs over a period of one month.

1. Collect Rent Revenue

In property management, spaces are leased, or rented, to tenants. The accounting cycle begins with receiving rent and depositing the funds into the bank account.

2. Accounts Payable

Accounts payable is the accounting function that pays and tracks invoices received for products and services needed to run the business. Property management invoices may include those for maintenance, utilities, property taxes, and other operating expenses.

3. Bank Reconciliations

Bank reconciliations are done monthly once the bank statements are received to verify that all rental revenue and operating expenses have been recorded correctly and there is no unexpected or unexplained cash transactions

4. Financial Reports

To complete the accounting cycle for property management, financial reports must be generated. The reports are required for external users including taxing authorities, lenders, and investors. Financial reports are used internally to monitor the financial position of the property and make decisions about future operations.

Rows of windows on the side of an apartment building, symbolic of a business that may require property management accounting.

Property Accounting Terms and Tools

Many of the terms used in property management are similar to general accounting terms, but there are some that carry more weight or are unique to this specific industry. Understanding the meaning of property accounting vocabulary will make a journey into property management much smoother. There are also tools that can be used to make property accounting more efficient. Some common property management terms and tools are described in the list below.

Cash Basis/Accrual Basis

An accounting method must be chosen when starting the books for any business. A cash basis accounting method records transactions as the money comes into or out of the company. In a company that uses cash accounting, rents are recorded onto the ledger as income at the time the funds are received.

Property accounting using an accrual basis means recording transactions when they are due to occur. In a company using the accrual basis, rent would be recorded to the ledger as income on the date it is charged or due, usually the first of the month.

Triple Net/Gross

Triple Net and Gross are both terms that describe lease types. In a gross lease, the tenant pays a monthly base rent, as agreed upon in the lease. The tenant does not share the cost of operating expenses.

 A triple net lease, or NNN lease, means that the tenant pays their pro-rata share of operating expenses and real estate taxes in addition to their base rent. With a NNN lease, operating expenses and property taxes may be paid monthly with base rent based on an estimate provided by the landlord. Some landlords choose to only collect base rent monthly, and bill tenants, following an expense reconciliation, annually.

Trailing 12

A trailing 12 is a term used to describe a format of an income statement. The income statement is also referred to as the profit and loss statement of a business and lists the revenues and expenses to calculate the Net Income. A trailing twelve shows twelve months of income and expenses in one report so that landlords and accountants can see trends from month to month. It is an important tool in analyzing property accounting records because it quickly shows any change in rents or expenses.


A budget lays out the financial plan for a period, usually one year. The budget lists the revenues and expenses that are reasonably expected to happen. A complete and thorough budget is an important analysis tool in monthly reviews of financial statements because it allows the accountant or property owner to track if rents and expenses are occurring as expected.

A forecast is another financial planning tool often used in conjunction with the budget. Proper forecasting gives cash flow expectations for the near future and changes as time goes on. A forecast essentially updates a twelve-month budget with actual data as the months conclude changing the cash flow and income expectations in future months.

Rent Roll

A rent roll is a report that lists each unit in a property. The report lists the tenant, the square footage, the base rent, and important dates. A rent roll is an acceptable way to show current occupancy when working with accounting firms and lenders.

1031 Exchange

The term 1031 Exchange is taken from the IRS Code Section 1031. The 1031 exchange allows real estate investors to defer tax on capital gains by exchanging like-kind property. Basically, when one property is sold, the owner can defer the income tax by purchasing another property within the allowed timeframe. Anyone in the business of buying or selling real estate should speak with their tax advisor regarding the benefits and applications of the 1031 Exchange rules.

Property Management Software

Quite possibly the most important property accounting tool is property management software. Smaller property management companies or individuals owning one or a few buildings may be able to document their financial transactions using a spreadsheet, like Excel. However, because accounting for property management often includes multiple entities and separate accounts for the tenants and the property, good software simplifies the process.

Accounting software that is dedicated to property management, like AppFolio or Onesite, saves time, frustration, and money on generating financial reports, recording rents and expenses, and tenant communications. Purchasing software can be confusing and expensive but using an accounting service to access great property management software is another efficient way to have the best tools in the business.

Final Thoughts

Property management is not for everyone, but many business owners and individuals find that it is a great way to invest in long-term assets while generating income. Accounting for property management requires patience and an overall understanding of the industry-specific terms and expectations beginning with the accounting cycle. For all types and sizes of property management, there are software packages or outsourced accounting services available to aid in the process. One such accounting service is My OC Bookkeeper. We love working with property management companies all over Southern California (and beyond). So if you are looking for a partner to help with your books reach out to us today.

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