Capital expenditures are an important thing to understand, and be prepared for, in any real estate investment. Understanding what capital expenditures are, how they're taxed, and how to budget for them can have a significant impact on your real estate profits.
What are capital expenditures?
Capital expenditures are the money used to add to or improve a property beyond common repairs and maintenance. Capital expenditures are used for investment properties, equipment, and other fixed business assets. Many people refer to capital expenditures as capex.
Since the cost related to these improvements is usually substantial, many real estate investors with long-term goals set aside cash from their monthly revenue to put into reserves. Having reserves in place protects investors from the large capital outlay when a major repair or improvement is needed. Having cash available to cover these capital expenditures is important to be able to keep receiving cash flow from the property.
Money set aside for these reserves is not listed as an expense on the income statement like operating expenses are. Although the reserves affect your free cash flow, capital expenditures are only reported on taxes when you actually have the expense of the improvement or repair.
While an income statement may show the entire cost of the capital expenditure to show a true picture of annual cash flow, it is a depreciation expense on your financial statements and tax return. The depreciation schedule will depend on what's included in the specific improvement or equipment. The expense may even qualify for bonus depreciation or a Section 179 deduction.
What is included in capital expenditures for real estate?
Common capital expenditures for a real estate asset, like rental properties and commercial real estate, include improvements to the property such as renovations and major repairs. Some major repairs made to upgrade and maintain the property include replacing the roof, windows, or siding. A capital expenditure is intended to improve the component to like new condition or extend the life of the asset. Purchasing certain equipment to be used in the operation of a real estate investing company would also be considered a capital expenditure.
In fact, a capital expenditure is considered an investment into the business instead of an expense that affects cash flow. A company's balance sheet will show any funds used by a company for capital expenditures listed as an investment. The expense listed on the financial statements will be the depreciation from that capital investment.
Examples of capital expenditures for real estate include:
- New roof.
- New HVAC.
- Major appliances.
- New flooring.
- Complete overhaul of plumbing or electrical.
- Bathroom and kitchen remodels.
- Paving (not repairing) a parking lot or driveway.
Capital expenditures vs. maintenance and repairs
In some instances, trying to determine whether a certain repair or improvement is considered a capital expenditure or a repair or maintenance can be confusing. In most cases, you can ask yourself whether the project is returning the asset to its previous condition or returning the property to like-new condition.
For example, replacing an entire roof would be a capital expenditure because it is a new roof and is extending the asset's life. Repairing a section of a roof is simply a repair and is included with ordinary operating expenses because it's only allowing the asset to continue its current useful life.
An improvement to the asset that isn't necessary to continue its useful life but is instead made to increase the value is considered a growth capital expenditure. Repairs needed for the asset to continue being useful are considered maintenance capital expenditures.
Examples of capital expenditures vs. repairs and maintenance
|Buying a new furnace||X|
|Replacing parts of a furnace||X|
|Upgrading the electrical panel||X|
|Replacing light fixtures||X|
|Building a new deck||X|
|Installing a sprinkler system||X|
|Replacing smoke alarms||X|
Of course, there will be some situations where it will be difficult to determine whether the cost of a project should be an expense or a capital expenditure. The Internal Revenue Service (IRS) has provided an FAQ on their tangible property regulations to clarify some of these situations. It's important to know what expenses to include in your financial statements when preparing your tax return.
How do you budget for capital expenditure reserves?
To avoid a large cash expense when major repairs are made, most investors prefer to calculate capital expenditures and set aside reserves on a monthly or annual basis. These reserves are often referred to as capex reserves. When you put away a set amount of cash each month, you factor that into your free cash flow so the cost of a capital expenditure won't be a large blow to your business if the cash isn't available.
Investors have different ways they prefer to calculate their capital budget for cash reserves. Some common methods of budgeting for capital expenditure reserves are:
- Percentage of revenue.
- Percentage of property value.
- Set amount per unit.
- Based on current age of items to replace and cost of replacement.
In many instances, a lender will determine the amount the borrower must set aside for reserves. They may even escrow that into their monthly payments and hold the cash reserves themselves. A lender will do this to protect the asset they're holding as collateral on the loan.
If you've ever looked up how much to budget for reserves, you've likely seen widely varying opinions. This can make it tough to decide how to calculate capital expenditures. Of course, the amount of cash you set aside should be different depending on the age and condition of the property.
For example, if you purchase a rental property that was just built, you'll probably be safe setting aside a smaller amount of cash and building up your reserves over time. If you purchase a property with a roof that's already 12 years old and that has old aluminum siding, you'll likely want to set more cash aside each month to build up your reserves faster. Figuring out ahead of time how much you can expect to pay to replace big-ticket items will help in your budgeting.
Be careful in choosing how much to budget for capital reserves. Not budgeting enough can leave you digging pretty deep into your pockets when things come up. On the other hand, budgeting too much will take away from your free cash flow. It's unlikely that you will get the perfect balance, but over time you will get better at estimating how much you should budget.
One simple way to determine a reserves budget is to use a calculator that factors in the age of things like the roof, foundation, driveway, appliances, etc., along with the expected useful life of each and the estimated total cost of replacing them.
Capital expenditure calculator
|Capital Expense||Replacement Cost||Lifespan (years)||Current Age||Remaining Life||Cost per Year||Cost per Month||Annual Budget||Monthly Budget|
|Structure (foundation, framing)||$10,000||50||30||20||$200||$16.67||$500||$41.67|
|Components (garage door, etc.)||$1,000||10||2||8||$100||$8.33||$125||$10.42|
How do capital expenditures affect profit?
When a capital expenditure is paid for, the cash spent won't be reflected on the income statement for that fiscal year, so there won't be an immediate effect on the company's profit. Instead, the reported profits will be reduced each year that the improvement to the asset is being depreciated. The depreciation expense will be listed on the income statement and deducted each year according to the depreciation schedule for that particular capital expenditure.
Capital expenditures also affect profits because they are an investment into the property that allows it to continue generating revenue and control costs. Some investors will avoid spending money on needed repairs and improvements for as long as possible. This not only results in having to lower rent because of the poor condition of the property but often leads to more expensive repairs to the asset later on. For example, if a landlord avoids replacing shingles on a roof for too long, they may then have to replace sheathing or may even have water damage and mold to deal with.
Avoiding capital expenditures can also have an extremely negative effect on profits if it's related to safety issues. An outdated electrical system could result in a fire. A rotting porch or deck could result in serious injuries. Besides the moral obligation to keep the property safe, lawsuits and increased insurance rates will have a long-term effect on your net income.
The bottom line
Capital expenditures are something that should never be overlooked when you invest in real estate. Understanding what is considered a capital expenditure and how they will affect your taxes will help you make smart decisions about how to handle projects on your investment property.
You also want to stay consistent with setting aside cash each month for your reserves and stay on top of the necessary repairs and improvements that will help your company avoid the stress of figuring out how to cover large expenses you weren't expecting. Being knowledgeable about all the different aspects of real estate investing, like capital expenditures, will help ensure your success as an investor.
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