Expenses might be routine in the construction industry but understanding the spend can have a significant impact on your balance sheet. Here’s why.
When it comes to expenses on your portfolio, money spent is money spent, right? To a certain extent that might be true. But understanding which bucket that money flows into–capital or operating expenditures–will make a difference in how you plan for that spend.
More important, construction property owners can deduct taxes for each category of expenses differently. Let’s dig into the differences between repairs, maintenance and capital improvements to better understand the tax impacts to your portfolio.
The Difference Between Repairs, Maintenance and Capital Improvements
The simplest way of evaluating the difference between improvements, repairs, and maintenance is to ask if the money goes toward improving the property value. If it does, it qualifies as improvements and is categorized as capital expenditures. If not, then it can be either repair or maintenance and falls under operating expenditures.
Repair and maintenance do not increase the value of the property, they simply bring it back to the original state. And while maintenance and repair are often mentioned in the same breath, the two are different in that maintenance is often proactive, executed before there is significant damage to construction.
Repairs fix damage and are the last resort to save structures and restore them to their original condition. An example of this would be replacing the evaporator coil to fix an HVAC system—this type of repair work does not generally increase the value of the property but rather keeps the status quo.
Maintenance is the effort to prevent the decline or damage of an asset. Annual service for an HVAC professional to check the system’s condition and performance would fall under maintenance.
Property owners are under tremendous pressure to keep an eye on longevity of buildings and their energy efficiency. As a result, predictive maintenance, where owners can tell in advance when building parts are going to fail, is gaining traction in the construction industry.
A capital improvement is generally an enhancement that extends the life and/or improves the value of an asset. The addition of a new wing at a hospital to support more patients would be considered a capital improvement. Infrastructure-related projects may also fall under this designation and federal funding should be taken advantage of while it’s still available.
For example, the Milwaukee Metropolitan Sewerage District (MMSD) has implemented a multi-tiered plan to replace aging infrastructure and build out new green infrastructure (GI) solutions, by managing projects of many types and sizes with the use of e-Builder Enterprise.
While certain repairs or maintenance can be classified as a capital improvement—capital improvements cannot be labeled maintenance.
HOW TO CLASSIFY EXPENSES AS IMPROVEMENTS VS REPAIRS AND MAINTENANCE
There are fine lines to look for when classifying expenses as improvements, repairs or maintenance:
- Repairs and maintenance can sometimes turn into capital improvements if the project is found to be too big to fix with just a few small repairs.
- For example, a property owner who hires a roofer to repair a few shingles on a hotel roof might find substantial rot and decide that it might be a better idea to replace the entire roof.
- Improvements can apply to entire buildings or individual components.
- For example, adding a new swimming pool to the hotel or replacing the facility’s HVAC system both count as improvements.
- Improvements extend the life of construction instead of simply preserving it.
- For example, replacing outdated siding with more energy-efficient siding will likely increase the lifespan of a building while also cutting utility costs. Such expenses are considered capital improvements.
- Fixing a flaw or design defect, enlarging a building’s capacity, retrofitting a building to improve energy efficiency, and rebuilding a building after it has reached the end of its economic life, all fall under capital improvements as per IRS rules.
- Finding a new use for an old building–for example converting an old mall into a new urban garden or health center–also qualifies as capital improvements.
- Any expenses incurred in extending the life of an asset is also considered an improvement.
- For example, using smart technology or digital twins for building lifecycle management can be considered capital improvement.
Examples of Maintenance, Repairs, and Capital Improvements
How Tax is Affected by Maintenance vs Repairs vs Improvements
Taxes are another factor to be taken into consideration when categorizing maintenance vs repairs vs capital improvements.
Portfolio owners can claim expenses for the repair and maintenance as deductions on the annual taxes. Expenses for improvements, on the other hand, cannot all be deducted in the year they were incurred. They need to be amortized over the lifespan of the improvement with a percentage deducted every year.
So while money spent on properties theoretically flows into the same known assets, owners need to categorize expenses. Understanding whether the money they spend qualifies as repairs and maintenance versus improvements will be key to managing your company’s business operations.
For tax filing purposes, repairs and maintenance fall into the operational expense (OpEx) bucket, while improvements are classified as capital expenditures (CapEx).
A note of caution: Because the tax buckets for the categories have been so fluid in the past, there has been a lot of confusion about whether certain expenses qualify as capex improvements or ongoing operating maintenance and repair. The IRS has published rules about Tangible Property Regulations to navigate the territory.
Sometimes categorization of expenses for construction portfolios can get confusing so when in doubt, it’s smart to talk to an accountant who can verify the tax implications for expenditures that can overlap a couple of categories.
Construction workers, contractors and property owners will always face expenses for extending the life of buildings or keeping them in stable, working condition. Understanding whether a particular expense falls as a capital improvement or maintenance or repair will help construction industry professionals spend their money more strategically for the short and long term.
As the world’s population grows and the pressures to extend the life of buildings and build sustainably grows, the construction industry is going to evolve and develop new ways of doing business. But the necessity for keeping an eye on business operations is not going to change. The topic of capital improvements versus maintenance and repair is one that is likely going to have to be revisited systematically over the years to come.
THE DEFINITIVE GUIDE TO DIGITAL TRANSFORMATION FOR OWNERS OF CAPITAL IMPROVEMENT PROGRAMS
Download our Definitive Guide to Digital Transformation for Owners of Capital Improvement Programs and learn why leveraging an advanced digital construction management solution like e-Builder Enterprise—which is designed for owners like you—will effectively aid in managing the funding, tracking and reporting of your infrastructure-related projects. Get your complimentary guide.