Cap Ex Breakout

[Andy Tomaswick]

Hi All,

I understand that it's extremely important to take capital expenditures into account when doing the numbers for a rental property.  However, I've been looking at several properties where they haven't had anything that would be conisdered "cap ex" expenses in the few years of expenses that they give me.  I'm assuming that I should consider this as they haven't been saving up for things like a new roof, new furnace etc, but I'm not sure how exactly to go about taking account of that.

I guess the first question I have is what all is considered to go into the "cap ex" category of expenses.  Roof, water heater, furnace, AC, kitchen remodel?  Am I missing anything?

The second question I have is how to best to budget for what I know is deferred cap ex spending - save up a higher amount from the rental income to play directly for it, or try to decrease the purchase price by some sort of amortized amount of the expected repair cost of the roof.

I hope those questions make sense and look forward to some feedback.  Thanks in advance!

[Oren K.]

Hi Tom,

With the disclaimer of speak to your accountant, to really simplify your first questions, anything that you can not directly deduct as an expense against income in the year that it is earned and must be 'depreciated' over time is CapEx. Things that generally fall into that category are as you mentioned, roofs, furnaces, paving, etc, etc. The IRS has rules in place defining how long a particular item has to be depreciated; Carpet 5 years, Appliance 10 years, Roof 20 years, Building Structure 30 years (just making up some numbers).

But as almost always, there are exceptions and conditions. For example, major rehab would generally be considered CapEx but there is an IRA rule that allows you to break down the project into individual tasks. Then, if a specific item (e.g. tiling kitchen floor) costs below a certain amount (threshold for 2015 was I believe $500), the cost of that task can be fully expensed and is not depreciated over time (Note that the cost is material and labor). This moves it from a CapEx to a direct expense against income which results in lower paid taxes or increased losses.

As a case in point, I am in the process of doing major work on a multi-family property. Because I had fairly detailed breakdown of material and labor for not only each unit but each task in each specific unit, my accountant was legally able to allocate some 75% of the costs to expenses and not CapEx. It requires more work upfront but it is worth the effort.

Also, from what I was told, the threshold for 2016 and moving forward has been increased to $2,500 per task. I my case, I believe all the unit remodeling will fall under expenses next year.

Another layer of complexity is when the federal / state government decides to 'encourage' spending. You see this periodically when they allow accelerated depreciation. An example would be that a computer would normally be depreciated over 3-5 years but they enact an exception that it can be depreciated over 2 years or fully expensed in the year it is purchased.

As always, speak to an accountant who knows both the IRS rules and your local state rules.

To your second question (this is getting long :), the simple answer is yes. If, when you do your due diligence on a property you determine that $X are needed immediately for health and safety work or obvious near term repairs, it is not uncommon to ask the seller for an abatement / reduction on the agreed upon price. If they refuse or are only willing to give a partial abatement / reduction, it is then up to you to determine IF you  can / are willing to invest the additional funds for immediate or near term repairs.

For longer terms repairs (e.g. Roof is showing its age but has another 5 years left in it), it is all about budgeting. I think most experienced investors would tell you to come up with a life cycle CapEx budget (e.g. Roof 20 Y, Boiler 10 Y, etc.) and set aside the funds needed each month / year so when you need them, they are waiting for you. I look at it this way, I would rather not be 'surprised' in 5 years when the HW tank needs to be replaced with a big bill. I would rather put funds aside for this. Putting funds aside for CapEx clearly affects the profits you can take from a property but you will have to pay one way or the other.

When / if you sell, any funds you have in your CapEx account simply come back to you.

Another aspect to this is if you are buy & hold investor or a short term holder / flipper. As a short term holder / flipper, you generally do not face the same needs. Assuming the rehab as done properly, you will have exited the property long before the need to replace any high ticket - long term items wear out.

Hope this helps and Good luck