Capital Replacement Costs

Submitted by Parthenon Commercial Group

The costs associated with commercial buildings, condominiums, home owners’ associations, etc., come in multiple forms. As noted in our previous article, reserve studies can help give an owner/homeowners’ association some clarity around what amounts and types of costs can be expected in the future based on the current condition of assets. An important piece of the overall cost of ownership is capital replacement costs. While some owners may view an expense as an expense, the effect of a capital replacement on your tax liability and general financial performance can be significant.

Capital replacement costs are the costs of purchasing an asset that will have a useful life in excess of one year (i.e., a capital asset). If a capital asset is purchased, it is not immediately deductible as a business expense, but depreciation deductions can be taken over an appropriate period. Given capital assets are typically a large expense, these purchases have a real impact on the financial performance of the property through a large cash outflow with limited allowable deductions in the same year as the purchase. This can be particularly difficult in the context of a homeowners’ association that does not have adequate capital reserve funds.

The decision of whether to purchase a capital asset will depend on whether the previous asset (if one exists) is no longer useful and whether the cost/benefit of repair would outweigh the cost/benefit of replacement. A reserve study can help with the cost/benefit analysis. That said, it is important to note that unless you indicate otherwise when you are obtaining a reserve study, the analysis will typically be limited to the property’s existing assets and their capital replacement costs during the relevant time horizon. If there are any planned capital improvements or capital asset purchases in the near future, you should discuss those items with your reserve study provider prior to the performance of the study.