From the Nolo Small Business Center

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 "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.

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.

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&emdash;§ 179&emdash;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.

Capitalizing Expenses

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).

Take advantage of the immediate Section 179 deduction.

A valuable tax break creating an exception to the long-term write-off rules is found in IRC § 179. A small business can write off in one year most types of its capital expenditures, up to a grand total of $24,000 in 2002 and $25,000 in 2003. Some assets don't qualify for this deduction: real estate, inventory bought for resale and property bought from a close relative.

All small businesses should take full advantage of this provision every year, unless they don't have enough business income to offset the § 179 deduction (the § 179 deduction can't exceed your total taxable earnings).

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.

Example:
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 repair expenses. In 2001, 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 all be taken in 2001 when the die stamper is rebuilt. The tax code says that metal-fabricating machinery must be deducted over five years.

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