As a real estate investor, landlord, or property manager, one of the biggest concerns you have is maintaining your rental property. This can include making repairs and replacements when necessary and making capital expenditures (CapEx).
In this blog post, we’ll look at what CapEx is and how it affects your bottom line. We’ll also provide tips on budgeting for CapEx in your rental properties.
Key takeaways
- CapEx is improvements that increase the value of a rental property.
- Rental property capital expenditures are added to the property cost basis and depreciated over a fixed period of years.
- CapEx can help to attract and keep qualified tenants, justify higher rent, and make a rental property more valuable.
- An investor can budget for future rental property CapEx by making regular contributions to a CapEx account.
What is a rental property CapEx?
A rental property CapEx is a long-term investment made to improve or increase the value of a rental property.
Common examples of CapEx real estate investors make on single-family rental (SFR) homes or multifamily buildings include reroofing, upgrading electrical or plumbing systems, and installing new windows or doors.
While these upgrades may not be immediately noticeable to tenants, they can significantly impact the property’s long-term value. In addition, investor-owners can make changes to the interior layout of a unit to make it more attractive to potential renters.
Because these costs can add up quickly, it’s crucial for real estate investors to carefully track CapEx to file taxes correctly and maximize return on investment (ROI) if the property is sold.
Difference between CapEx and repairs
CapEx is improvements made to increase the value of a rental property, such as building an addition, finishing a basement, or updating kitchens or bathrooms.
These improvements add to the property’s cost basis, which is the original purchase price plus the cost of any capital improvements. This cost basis is used to calculate depreciation deductions and capital gains taxes when the property is sold.
CapEx and depreciation
Depreciation is an annual expense that reflects the gradual wear and tear of the asset. It is calculated by dividing the cost basis by the number of years the asset is expected to last.
The straight-line method is generally used to calculate depreciation, which evenly spreads the depreciable basis over the asset’s useful life. For example, investors typically use a 27.5-year life for residential rental property to depreciate structural components such as walls, floors, and roofs.
For example, if you paid $100,000 for a rental property and spent $15,000 on improvements, your cost basis would be $115,000. If the property is depreciated over 27.5 years, your annual depreciation expense would be $4,182 ($115,000 divided by 27.5).
However, some items in a rental property, such as appliances, fixtures, and flooring, have just a 5-year life.
For example, if an investor spends $5,000 on new appliances, the depreciation expense would be $1,000 per year over the next 5 years. In some instances, an investor may be able to claim bonus depreciation and claim the entire depreciation amount of $5,000 the year that the items are placed in service.
Note that because depreciation is a noncash expense, it does not reduce your cash flow. However, it does reduce your taxable net income, which can ultimately save you money.
Repairs on rental property
In contrast, repairs are made to keep the property in good condition and generally do not increase its value. Common repairs include painting, fixing leaks, and replacing broken fixtures.
The Internal Revenue Service (IRS) allows landlords to deduct repair expenses from their taxable income as long as they are considered “ordinary and necessary.” For example, if gross rental income collected is $12,000 per year and a landlord spends $2,000 on repairs, the entire amount may be deducted as an operating expense to reduce taxable net income.
While some landlords hold off on making repairs, well-executed repairs can often preserve or increase the value of a rental property and lead to higher rents and longer lease terms. For example, if a landlord replaces leaky plumbing in the kitchen or bathroom, they can prevent water damage to cabinets or floors and may be able to charge future tenants more rent.
In addition, repairs can help to ensure that tenants are satisfied with their living situation and are less likely to move out prematurely. As a result, landlords should carefully consider whether repairs are worth the investment before making any decisions.
Understanding how CapEx is taxed
As a real estate investor or property manager, it’s essential to be aware of the tax implications of any repairs or CapEx made to your rental property.
Generally speaking, repairs are considered deductible expenses, which means they can be subtracted from your taxable income for the year they were incurred.
On the other hand, capital expenditures are considered long-term investments and must be depreciated over their useful life. This means you must deduct a portion of the cost each year rather than taking the entire deduction in the year of purchase.
While both types of deductions can save you money on your taxes, it’s important to understand the difference so that you can adequately plan for your CapEx.
Budgeting for rental property CapEx
As a rental property owner, you know that CapEx is a necessary part of owning and maintaining your investment. But what you may not know is how to budget for these expenses so that you’re never caught short.
The first step is to create a separate account for your CapEx funds to track precisely how much money is coming in and going out.
There are 2 main ways to budget for rental property CapEx:
- Set aside about 10% of the rental income collected for CapEx (more or less depending on the age of your property). For example, if you have an older property that requires more frequent repairs, you may want to set aside 15% to 20%.
- Alternatively, some experts recommend setting aside 1% to 2% of your rental property’s value each year into a CapEx account. For example, if your rental property is valued at $200,000, you should aim to put away $2,000 to $4,000 annually. This may seem like a lot, but even small expenses can add up over time.
Once you have your CapEx account established, never dip into it for any other expenses. This account is only for CapEx relating to your rental property.
Benefits of CapEx
Any experienced rental property owner knows that there are always ongoing costs associated with keeping the property in good condition and attracting and retaining tenants. But larger CapEx may be necessary, such as replacing a roof or heating, ventilation, and air-conditioning (HVAC) system, renovating an outdated kitchen or bath, or adding a new deck or fence.
While these types of projects can be expensive, they can have a significant impact on the value of the property and the ability to attract and retain quality tenants who may be willing to pay a higher rent.
In addition, the increased value of your property may help you get approved for more favorable loan terms in the future as lenders see you investing additional capital into your property. Capital improvements can be depreciated for tax purposes, which can offset some of the initial cost.
However, it is essential to remember that CapEx can be a significant financial commitment. Before embarking on major projects, do your research and create a detailed budget to ensure you don’t overleverage your investment.
With careful planning, CapEx can be a great way to improve the bottom line of your rental business.
Tips for keeping track of CapEx
Keep accurate records of all expenses related to your rental property. This will help you stay organized and on budget and provide a record in the event of an audit.
There are options for keeping track of your expenses. You can use a simple notebook, a spreadsheet, general-purpose accounting software, or free software specifically for rental property investors, such as Stessa, a Roofstock company.
Whichever method you choose, include all relevant information, such as the date of the expenditure, the vendor name, and the amount spent. Keep track of both one-time and recurring expenses. If you have multiple properties, open an individual bank account for each rental property. This will make it easier to track and categorize your spending.
By staying organized and keeping a record, you can ensure that your rental business is running smoothly and efficiently and that your return on investment is solid and healthy.
Final thoughts
Rental property owners are always looking for ways to keep their properties in good condition and attract quality tenants. CapEx or more extensive repairs or improvements can significantly impact the property’s value.
While these projects can be expensive, they can provide benefits, such as increasing the value of the property, helping you get approved for more favorable loan terms, and enabling you to depreciate the cost for tax purposes.
However, CapEx can be a significant financial commitment, so do your research and create a detailed budget before embarking on any major projects. With careful planning, CapEx can be a great way to improve the bottom line of your rental business.
