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When you may deduct a given expense depends in part on what type of expense it is: current or capitalized.

Tax rules cover not only what expenses can be deducted but also when – 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 are expected to generate revenue in future years. These are “capitalized” – that is, they become assets of the business. As these assets are used, their cost is “matched” to the business revenue they help earn. This, theoretically, allows the business to more clearly account for its profitability from year to year.

However, it is not always clear what is a current expense and what is a capital one. Normal repair costs, such as fixing a broken copy machine or a door, are obviously 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 its 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 capitalization 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 be taken all in 2001 when the die stamper is rebuilt. The tax code says that metal-fabricating machinery must be deducted over five years.

The general rule is that costs for items with a “useful life” of one year or longer cannot be deducted in the same way as current expenses. Rather, asset purchases are treated as investments in your business, and must be deducted over a number of years, specified in the tax code (with one important exception, discussed below). The deduction 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 difference 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).

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 2001). All profitable small businesses should take full advantage of this provision every year.

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