Distinguishing maintenance and capital expenses

[Seth C.]

Looking at P&Ls I see a lot of stuff that is placed in capital expenses that seems like it should be in maintenance, ie above the NOI line--but I don't know completely what the industry standards are.

There are things like carpet replacements, or vague "interior repairs", exterior repairs, electrical, etc.

So, Where do we draw the line, and are there any good resources/lists that can help on this one? Do you just deal with those vague items in due diligence with an amended offer?

Thanks! Seth

[Brandon Hall]

@Seth C.

When speaking in terms of repairs vs. capital improvements, we will be referencing the IRS Final Tangible Property Regs. They provide guidance on how to determine whether an expenses is a repair or an improvement. You used to have a lot of leeway in classifying expenses as repairs, however, the Final Regs make it hard to classify expenses as repairs over capital improvements.

That said, you will need to provide a lot more information for anyone to accurately tell you one way or the other. Even with the extensive Final Regs, there are a lot of loopholes to take advantage of.

One example is flooring (regardless of whether it's carpet or hardwood). If you have 10 units, and you replace the floor in two units, you can argue that you have replaced 20% of all floors in the building. That's not a material portion of the floors in total, so you can likely deduct those expenses as repairs in the current year.

Another example would be the plumbing system (now the building is divided into Units of Property (UOPs), which essentially separates out the various systems in the building. Making a repair to a system, isn't considered a repair to the building, but a repair to the system itself, so you have to understand how that repair affects the specific system to correctly categorize the expenses as a repair or capital improvement.) If you have that same 10 unit building and you replace three toilets, two bath tubs, some piping, and a couple of vanities, it can be argued that those expenses should be capitalized and depreciated because you likely made a material improvement to the plumbing system itself.  

A last example is the air conditioning system. If you have that same 10 unit building, all with their individual HVACs, and you replace two of the HVACs, you have only replaced 20% of the building's air conditioning system. Therefore, you can argue you did not materially improve the air conditioning system and therefore can deduct the expense in the current year as a repair.

Hope this helps.