Tax rules cover not only what expenses can be deducted but also when -- in what year -- they can be deducted. Some types of expenditures are deductible in the year they are incurred but others must be taken over a number of future years. The first category is called current expenses, and the second capital or capitalized expenditures. You need to know the difference between the two, and the tax rules for each type of expenditure. We'll try to make it easy on you, but there are some gray areas.
When Is an Expense Capitalized?
Current expenses. Generally, current expenses are everyday costs of keeping your business going, such as the rent and electricity bills. Rules for deducting current expenses are fairly straightforward; you subtract the amounts spent from your business's gross income in the year the expenses were incurred.
Capitalized expenses. Other business expenditures, such as the cost of equipment, land, and vehicles to name a few, cannot be deducted in the same way as current expenses. Asset purchases, since they are expected to generate revenue in future years, are treated as investments in your business. They must be deducted over a number of years, or capitalized, as specified in the tax code (with one important exception -- Section 179 -- discussed below). This, theoretically, allows the business to more clearly account for its profitability from year to year. The general rule is that if an item has a useful life of one year or longer, it must be capitalized.
The deduction taken over a number of years is usually called depreciation, but in some cases it is called a depreciation or amortization expense. All of these words describe the same thing: writing off or depreciating asset costs through annually claimed tax deductions.
There are many rules for how different types of assets must be written off. The tax code dictates both absolute limits on some depreciation deductions, and over how many future years a business must spread its depreciation deductions for all asset purchases. Businesses, large and small, are affected by these provisions (IRC §§ 167, 168, and 179).
Section 179 deductions. A valuable tax break creating an exception to the long-term write-off rules is found in IRC Section 179. A small business can write off in one year most types of its capital expenditures, up to a grand total of $500,000 in 2012 and 2013. These limits were approved under the tax law passed by Congress on January 1, 2013. This is subject to a phase-out after you reach $2,000,000 or more of eligible Section 179 expenditures. Some assets don't qualify for this deduction: real estate, inventory bought for resale, and property bought from a close relative. It's almost always a good idea to take full advantage of Section 179 when you can, unless your business doesn't have enough income to offset the deduction (the Section 179 deduction can't exceed your total taxable earnings). The Section 179 annual limit went down to its original $25,000 amount in 2014. There is legislation to increase the limit for 2014. Watch for updates in this area.
Bonus depreciation. In addition to Section 179, there is a special depreciation deduction for new qualified property called bonus depreciation, Bonus depreciation allows taxpayers to depreciate an additional percentage of the adjusted basis of qualified property in the first year the property is placed in service. For 2012 and 2013, the bonus depreciation amount is 50%. This deduction can be taken in addition to Section 179, although there are additional restrictions on its use. Bonus depreciation expired in 2014 so it is no longer available unless Congress acts to restore it.
Repairs and Improvements
Normal repair costs, such as fixing a broken copy machine or a door, are current expenses and so can be deducted in the year incurred. On the other hand, the tax code says that the cost of making improvements to a business asset must be capitalized if the enhancement:
- adds to the asset's value, or
- appreciably lengthens the time you can use it, or
- adapts it to a different use.
Improvements usually refers to real estate -- for example, putting in new electrical wiring, plumbing, and lighting -- but the rule also applies to rebuilding business equipment.
Gunther uses a specialized die-stamping machine in his metal fabrication shop. After 15 years of constant use, the machine is on its last legs. His average yearly maintenance expenses on the machine have been $10,000, which Gunther has properly deducted as a repair expense. Gunther is faced with either thoroughly rehabilitating the machine at a cost of $80,000, or buying a new one for $175,000. He goes for the rebuilding. The $80,000 expense must be capitalized -- that is, it can't be deducted using Section 179 because it is an improvement -- not a normal repair. Under the tax code, metal-fabricating machinery must be deducted over five years.
For more details on deducting expenses, as well as information on how to avoid audit triggers, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo).