Capital Expenses vs Operating Expenses: What’s The Difference?

We take a look at operating expenses vs capital expenses, how they need to be treated, and how landlords can maximize end-of-year deductions.

Running a rental business comes with a variety of expenses, from mileage and travel expenses to maintenance and repairs to wages and office costs. A lot of the expenses that go towards the operation and maintenance of your rental business are deductible at the end of the year, including your operating expenses.

However, not all can be immediately deducted immediately. Some, such as your capital expenditures will need to be depreciated over what is deemed their useful lifetime. In this article, we take a look at the differences between operating expenses and capital expenses, how each needs to be treated, and what landlords need to know in order to maximize their end-of-year deductions.

About capital expenses

In regard to rental properties, capital expenses are expenses that add value to the business. For example, the addition of a garage, the renovation of a kitchen, or the installation of new and better appliances. These major upgrades and renovations increase the value of the property and the overall rent that you can charge on an ongoing basis. Because they add value to the rental and your overall business, they need to be classified differently to everyday and normal expenses.

In order to reclaim the value of capital improvements or capital expenses, you will need to add the cost of the expense to your balance sheet and depreciate the value of the expenses over its useful lifetime.

For example, if you renovated the main bathroom, thus increasing the value of the property, you would add the value of the improvement to the cost basis of the property and depreciate it alongside the property. If you bought a new appliance, you would depreciate that over what the IRS deems its useful life. This is often around seven years but can vary broadly depending on the asset. The easiest way to determine the useful life of an asset is to consult IRS publication 946 or consult with a licensed financial professional such as your CPA.

Whilst investments in capital expenditures may decrease your annual cash flow, they are investments into the property and increase the overall property value in the long term. Capital expenses need to be carefully tracked and monitored, not only so that they can be accurately depreciated and the value reclaimed against your taxes, but also as evidence for lenders and investors to prove that you are adding value to the business.

kitchen renovation

About operating expenses

Rental property operating expenses are the day-to-day costs that your rental business incurs. These expenses must be ordinary and customary. Your rental property operating expenses will need to be reported at tax time and can be deducted from your taxes for the year in which the expenses were incurred. The following are examples of operating expenses that are applicable to rental properties:

  • Utilities
  • Wages and salaries
  • Accounting and legal fees
  • Property taxes such as HOA fees
  • Interest on debt such as credit card debt or your mortgage repayments
  • Routine repairs and maintenance
  • Marketing costs

For a full list of deductible expenses for your rental property visit our article on deductible expenses here.

Operating expenses are one of the main ways for landlords and real estate investors to maximize cash flow. Landlords need to have a financial tracking tool capable of keeping accurate and detailed records of all deductible expenses incurred throughout the tax year.

Landlord Studio is one such tool, easily track income expenses, digitize receipts, collect rent, and more.

Key differences between operating expenses and capital expenses

In short, capital expenses are major purchases that add value to your property and your rental property business. These improvements cannot be deducted at the end of the year but must instead be depreciated over their useful lifetime.

Operating expenses, on the other hand, represent the day-to-day operational costs of running your business. These are deductible in the year in which they are incurred. It is vital that landlords keep careful records of all of these deductible expenses so that they can be deducted against one’s taxes and used to maximize overall cash flow and profitability.

Related: Rental Property Deductions Checklist

Tracking your rental property income and expenses

In order to ensure that you claim the maximum amount in deductible expenses, landlords should employ modern software solutions. With Landlord Studio, you can easily update your accounts on the go using the mobile app or via desktop.

Landlord Studio is a cloud accounting, income and expense tracking property management software. In addition to the income and expense tracking tools, professional reporting, and receipt scanner, it has a suite of property management tools designed to help save you time and money. These include online rent collection, rental listings, tenant application management, tenant screening, automated rent reminders and more.

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