When Repairs Are Not Expenses

Bookkeeping that records every payment for property repairs as an expense completes the fiction that cash outflow is always found on the business Income Statement – also known as the Profit and Loss. In fact, the Balance Sheet reveals whether money was directed to the vital actions of decreasing debt or increasing assets. Expenditures for so-called capital goods appear on the Balance Sheet as fixed assets. These items – such as equipment and buildings – are distinctive from ordinary operating expenses on the Income Statement.

Capital goods can be repairs to existing fixed assets. The cost for these expenditures is depreciated over time rather than immediately appearing as expense on the Profit and Loss. A substantial burden for operators of small businesses is therefore the initial determination of whether a cost is a repair expense or a depreciable capital expenditure.

The Problem With Repairs

Improvements to existing fixed assets comprise a new capital expenditure when the cost is sufficiently high for capitalizing and extends the useful life or functionality of a fixed asset. These are distinguished from repair expenses, which are minor alterations. Capital improvements are generally structural – such as a new roof for a building. More cosmetic costs – like painting – are expensed as repairs.

Distinguishing between a repair and a capital improvement, however, is immersed in confusion. To decode the complexity, taxing authorities have released some general guidelines. A capital improvement is an expenditure that causes a property to undergo betterment, adaptation, or restoration – easily remembered as “B.A.R.“ Determining if any of these conditions applies necessitates comparing the condition property when it was purchased – or when the last work on it was performed – to its condition after the new expenditures.

Detailing B.A.R

Betterment ameliorates a deficient condition in property. Betterments also add to a property’s capacity, size, or quality. Adaptations change a property to a new use that’s different than the original purpose.

Restoration returns property to its ordinary efficiently operating condition. Moreover, a restoration applies to any major component of a property that contributes to its substantive function. This is the trickiest element of identifying a capital improvement. In means, for example, that replacing the motor necessary for a machine to run properly is a capital expenditure despite not replacing the entire equipment. Work performed on smaller assets – such as machinery – is commonly a capital expenditure. That is, a crucial component in the usefulness of equipment is very likely a capital improvement when replaced – unless the cost is minimal.

Conversely, large properties – like buildings – are more likely to incur repair expenses. Unfortunately, tax rules require dividing a building into multiple property units. The entire building is not a singular property. Rather, each system in the building is considered separately. Hence, replacing the air conditioning compressor is possibly a depreciable capital improvement since the ventilation system is viewed as a distinctive property unit.

In sum, uncovering whether expenditures are repairs or capital improvements is seldom easy. Consultation with a tax expert is a sound practice when these costs are incurred so that purchases are correctly recorded in the financial data of a small business.

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