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.
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).
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.