As the tax year winds down, real estate investors often scramble to reconstruct property spending from inboxes and bank statements. That last-minute approach can cost them, according to CostSegRx, an engineering-based cost segregation firm. Brian Kiczula of CostSegRx said property owners should document all capital improvements and expenses throughout the year, not just at year-end. The goal is a clear record of what work was done, when it was done, and what it cost.
Many investors lump every property cost together and try to expense all of it, but that is not how those costs are treated for tax purposes. When a CPA or cost segregation professional reviews spending, they typically apply the BAR test, which asks whether each cost is a betterment, an adaptation, or a restoration. Costs meeting one of those definitions generally must be capitalized and depreciated over 27.5 years for residential rental property, 39 years for commercial property, or shorter lives of 15, 7, or 5 years. Costs that do not meet the test usually fall into repairs and maintenance, which can be deducted in the year incurred. That distinction is why records matter: without them, there is no reliable way to tell which bucket a cost belongs in.
In CostSegRx’s experience, the gap almost always comes down to individual receipts and a clear description of the work performed. Owners tend to fall into two groups. One keeps every receipt in a Google Drive or Dropbox folder and tracks each improvement, with dates, in a spreadsheet. The other knows roughly how much they spent over the year but cannot say how that money was divided among new flooring, windows, lighting, or a bathroom remodel. The second group is often not at fault because many contractors bill in lump sums without breaking out what each part of the project cost. For owners in that position, CostSegRx uses construction cost estimating. Working from the owner’s description of the work and images of the property, the team rebuilds the contractor’s costs so each improvement can be classified.
For the rest of this year and going forward, the most useful habits are simple: save the receipt or invoice for each project, write a short note on what was actually done, record the date the work was completed, and take photos of the finished improvement. Owners who acquired a property this year need the same documentation, plus one more detail: when the improvements were placed into service compared with the property itself. If renovations were finished before the property went into service, the original cost segregation study may need to be adjusted. For example, if an owner replaced all the carpet before the building was placed into service, the old carpet had no value. It would be removed from the purchase price allocation, and the new carpet would be added in its place. If the property went into service first and a major remodel followed a few months later, the owner’s tax preparer would typically receive two separate fixed asset schedules, one for the acquisition and one for the remodel. The same approach applies when a property is bought one year and renovated the next, a pattern CostSegRx often sees with hotels.
Disorganization is common among landlords, and it is understandable. Owners are running the business of their properties, and most do not have a team tracking every expense. According to CostSegRx, being disorganized is usually the rule rather than the exception, but that does not mean the opportunity is lost. CostSegRx recently completed a study on a multi-year renovation of three buildings: a restaurant, a boutique bed and breakfast, and a group of shops. The owner did not have the original construction data, and the team was still able to produce a quality study. As long as an owner can document that the improvements were made, a study can usually still be done. The practical takeaway is to stop treating documentation as a year-end task, keep records as work happens, share them with your CPA, and ask early how any renovations will be classified.
