Yes, real estate should be capitalized. Under IRS rules and standard accounting practice, the purchase price of land or a building, the costs of constructing one, and most major improvements have to be recorded as long-term assets and recovered through depreciation over many years rather than deducted all at once. Routine repairs and maintenance are the exception and can still be expensed in the year you pay them. Getting the line wrong exposes you to a 20% accuracy-related penalty on any resulting tax underpayment.
Why Real Estate Always Has to Be Capitalized
Two tests decide whether any expenditure has to be capitalized. First, useful life: if the cost delivers a benefit lasting more than 12 months, it gets capitalized instead of expensed. Second, materiality: the amount has to be significant enough to warrant tracking as a separate asset. Real estate clears both by definition. Buildings last decades, and even modest properties cost far more than any reasonable materiality threshold.
Land is the cleanest case. Because land doesn’t wear out, its useful life is indefinite. You capitalize the purchase price permanently, and you never depreciate it.1Internal Revenue Service. Publication 946 – How To Depreciate Property Buildings and other structures do have finite lives, but those lives run far past a single tax year, so they get capitalized too. The same logic applies whether you buy an existing property or build from the ground up.
What Gets Rolled Into the Capitalized Cost
Your capitalized cost basis is more than the number on the purchase contract. It includes every expense required to acquire the property and get it ready for use, and many of those charges sit on the settlement statement where they’re easy to miss.
According to IRS Publication 551, closing costs that become part of your basis include:
- Legal fees for title searches, contract preparation, and deed drafting
- Owner’s title insurance
- Surveys and recording fees
- Transfer taxes
- Utility connection charges
- Amounts the seller owed that you agreed to pay, such as back taxes, sales commissions, and repair charges
Broker commissions you pay to facilitate the purchase also fold into the basis.2Internal Revenue Service. Publication 551 – Basis of Assets The total becomes your starting point for depreciation and for calculating gain or loss when you eventually sell.
Investigatory Costs Are Different
Not everything you spend before closing gets capitalized. Regulations draw a line between investigatory costs and facilitative costs. Investigatory costs are what you spend while deciding whether to buy a particular property, such as preliminary market research or an initial feasibility study before you’ve committed. Those can generally be expensed. Facilitative costs kick in once you’ve decided to move forward on a specific property, and they include the lender’s appraisal, the title search, and environmental inspections. Those must be capitalized.
Demolition and Construction Interest
Buy a property planning to tear down what’s on it, and the entire original basis is allocated to the land rather than the building. Demolition costs get added to the land basis as well, which means they’re never depreciable.3eCFR. 26 CFR 1.165-3 – Demolition of Buildings
When you build rather than buy, Section 263A of the Internal Revenue Code requires you to capitalize interest on debt used to finance construction of real property, treating that interest as a real cost of creating the asset rather than a current expense.4Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses The requirement applies to “designated property,” which includes real property with a long production period or an estimated production cost above $1 million.5Internal Revenue Service. Interest Capitalization for Self-Constructed Assets Property taxes and insurance premiums during construction get capitalized under the same rules.
Repairs vs. Improvements After You Own It
Once the property is in service, every dollar you spend on it raises the same question: expense now or capitalize? The Tangible Property Regulations set the framework, and the distinction turns on whether the work maintains the property or materially changes it.6Internal Revenue Service. Tangible Property Final Regulations
Routine maintenance such as painting, patching a leak, or swapping a few broken fixtures restores the property to its existing condition without meaningfully increasing its value or extending its life. You expense those costs in the year you pay them. Capital improvements change the property in a lasting way, and they fall into three categories:
- Betterment: fixes a pre-existing defect, increases capacity, or makes the property materially more efficient. Upgrading to a high-performance roof qualifies.
- Restoration: returns a major component to like-new condition. Replacing an entire HVAC system or rebuilding a foundation fits here.
- Adaptation: converts the property to a substantially different use, such as turning a retail storefront into a medical clinic.
The regulations divide a building into “units of property,” including the structure itself, the HVAC system, plumbing, and electrical. Replacing an entire unit of property has to be capitalized and depreciated over its own recovery period, even if the replacement was driven by normal wear rather than a bigger improvement plan.
The De Minimis Safe Harbor
For smaller costs, the IRS offers a shortcut. If your business has an Applicable Financial Statement (typically an audited financial statement), you can elect to expense items costing up to $5,000 per invoice or per item.7Internal Revenue Service. Tangible Property Final Regulations – Section: De Minimis Safe Harbor Election Businesses without an AFS use a $2,500 threshold, which the IRS raised from the original $500 in Notice 2015-82.8Internal Revenue Service. Notice 2015-82 – Increase in De Minimis Safe Harbor Limit for Taxpayers Without an Applicable Financial Statement The election is made annually on your tax return, and it lets you skip the capitalization analysis for purchases under the threshold.
How You Recover the Cost: Depreciation
After you’ve capitalized the cost, you recover it gradually through depreciation. The Modified Accelerated Cost Recovery System sets the schedule based on property type:
- Residential rental property, such as apartment buildings and rental houses: 27.5 years
- Nonresidential real property, such as offices, retail, and warehouses: 39 years
Both use the straight-line method, so you deduct the same amount each year. Both also follow the mid-month convention, which treats you as though you placed the property in service at the midpoint of the month you actually started using it.9Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System Close on a commercial building in March, and your first year’s depreciation covers 9.5 months. The same convention applies at the other end when you sell.
Land is never depreciated, which makes the split between land value and building value critically important. Every dollar allocated to land is a dollar you won’t recover through annual deductions.
Splitting Land From Building
When you buy an existing property, the purchase price covers both, but you have to split them for depreciation. The most common approach uses the ratio from your local property tax assessment, which separately values the land and improvements. An assessment showing 25% land and 75% building means you apply that same ratio to your total capitalized cost. An independent appraisal is another accepted method and can be preferable when the tax assessment looks out of step with market reality. The IRS doesn’t mandate one method, but your allocation has to be reasonable and defensible.
Where It Goes on the Return
You claim depreciation annually on Form 4562, filed with your business or rental return.10Internal Revenue Service. About Form 4562 – Depreciation and Amortization The same form handles Section 179 deductions, bonus depreciation, and amortization, and it’s required in any year you place depreciable property in service or claim a Section 179 deduction.11Internal Revenue Service. Instructions for Form 4562
Ways to Speed Up the Deductions
The standard 27.5- or 39-year schedule spreads your deductions thin. Several provisions let you recover costs much faster, and the tax savings in early years can materially change your cash flow.
Cost Segregation
A cost segregation study breaks the building into individual components and reclassifies the ones that don’t need to ride the full 27.5- or 39-year schedule. Carpeting, cabinetry, decorative finishes, and certain electrical work often qualify as 5-year property. Land improvements such as parking lots, landscaping, sidewalks, and drainage systems typically fall into the 15-year category. Reclassifying even part of the building into these shorter-lived buckets generates much larger deductions in the early years of ownership.
Section 179
Section 179 lets you deduct the full cost of qualifying property in the year you place it in service. For 2026, the maximum deduction is $2,560,000, phasing out dollar-for-dollar once total qualifying property placed in service exceeds $4,090,000.12Internal Revenue Service. Revenue Procedure 2025-32
For real estate, Section 179 is narrower than for equipment. It covers qualified improvement property, meaning interior improvements to nonresidential buildings other than enlargements, elevators, escalators, and internal structural framework.13Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System – Section: Qualified Improvement Property It also covers roofs, HVAC, fire protection and alarm systems, and security systems installed in nonresidential buildings after the building itself is placed in service. You can’t use Section 179 for the building shell or for any residential rental property.
Bonus Depreciation
The One Big Beautiful Bill Act permanently restored 100% bonus depreciation for qualifying property acquired and placed in service after January 19, 2025.14Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One Big Beautiful Bill Bonus depreciation only applies to property with a recovery period of 20 years or less, so the building itself (27.5 or 39 years) doesn’t qualify. Qualified improvement property (15 years) does, and so do the 5-, 7-, and 15-year components pulled out by a cost segregation study. Pairing a study with bonus depreciation is one of the more powerful real estate tax strategies: a buyer of a $2 million commercial building who reclassifies $400,000 of components into shorter categories can deduct the full $400,000 in year one instead of spreading it over 39 years.
What Capitalization Costs You at Sale
Capitalizing real estate and claiming depreciation creates a future tax obligation that catches many owners off guard. When you sell for more than your depreciated basis, the IRS wants back a portion of the benefit you received over the years. This is depreciation recapture, taxed at a maximum federal rate of 25% on the “unrecaptured Section 1250 gain,” which is the total depreciation you claimed during ownership. Any gain above that amount is taxed at the applicable long-term capital gains rate, assuming you held the property for more than a year.
Deferring With a 1031 Exchange
A like-kind exchange under Section 1031 lets you defer both capital gains and depreciation recapture by reinvesting the sale proceeds into similar real property. You have to identify the replacement property within 45 days of the sale and close within 180 days.15Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 Both properties have to be held for business use or investment; a personal residence doesn’t qualify. The gain isn’t eliminated, only deferred. Your basis in the replacement property carries over from the old one, so the recapture obligation follows you until you eventually sell without exchanging.
Records and Penalty Exposure
Capitalized real estate creates documentation obligations that last far longer than most people expect. The IRS requires you to keep records related to property until the statute of limitations expires for the year you dispose of the property, not the year you bought it.16Internal Revenue Service. How Long Should I Keep Records Hold a building for 20 years and then sell it, and you need the original closing statement, any cost segregation study, improvement invoices, and depreciation schedules for over two decades, plus three more years after the sale.
Misclassifying a capital expenditure as a current expense, or the reverse, can trigger the accuracy-related penalty of 20% on the resulting tax underpayment. The penalty applies when the IRS finds negligence or when the understatement is “substantial,” which for individuals means the greater of $5,000 or 10% of the tax that should have been shown on the return.17Internal Revenue Service. Accuracy-Related Penalty For a real estate purchase improperly expensed, clearing that threshold is almost automatic. Clean records and defensible capitalization decisions from the start are the cheapest insurance against that outcome.