Expenditures – Part 6
Expenditures – Part 6
In this article we continue our “Expenditures” series of articles with some discussion regarding capital expenditures.
Capital Expenditures
You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenditures.” Capital expenditures are considered assets in your business. There are, in general,
three types of costs you must capitalize.
- Business start-up costs
- New business assets
- Improvements and
restorations
New Business Assets
There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges. Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules.
Improvements or Restorations
You must separate the costs of repairs from the costs of improvements or restorations.
A repair keeps your property in good operating condition. Work done on your property that does not add much to either the value or the life of the property, but rather keeps the property in good condition, is considered a repair rather than an improvement. You can deduct the cost of repairs as a business expense that can be deducted in the year the work is performed.
Repainting your property inside or fixing gutters or floors, fixing leaks, plastering, replacing broken windows, or replacing parts of a machine that only keep it in a normal operating condition are examples of work that can usually be
classified as repairs.
An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Some examples of improvements are:
Exterior – heating/cooling systems or additions to existing ones, fencing or block walls, new landscaping, new water heater, new roof.
Interior – kitchen modernization, flooring, storm windows/doors, wall-to-wall carpeting, electric wiring or plumbing upgrades, adding insulation.
The costs of making improvements to a business or investment asset must be capitalized. The capitalized cost can generally be depreciated as if the improvement is separate property.
You must also capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration project. Furthermore, if you make repairs as part of an extensive remodeling or restoration of your property, the
whole job, including tasks that would by themselves usually be classified as a repair, must be capitalized.
For example, for the rehab of a unit that includes new carpeting and/or tile throughout, painting of the interior, new window coverings, and replacement of a broken kitchen faucet, the cost of the entire project is classified as a capital improvement even though replacement of a faucet and even the painting would usually be classified as a deductible expense when done alone.
Capital Expenditures vs. Deductible Expenses
To further help distinguish between capital expenditures and deductible expenses, some additional examples follow.
Motor vehicles – You usually capitalize the cost (or a percentage thereof) of a motor vehicle you use in your business. You can recover its cost through annual deductions for depreciation or under Section 179. There are dollar limits on the depreciation (or Section 179 deduction) you can claim each year on passenger automobiles used in your business. You can continue to deduct depreciation for the unrecovered basis resulting from these limits after the end of the recovery
period.
A passenger automobile is defined as any four-wheeled vehicle made primarily for use on public streets, roads, and highways and rated at 6,000 pounds or less of unloaded gross vehicle weight (6,000 pounds or less of gross vehicle weight for
trucks and vans). Larger vehicles or vehicles which have specialized uses are subject to different rules.
Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition and overhaul a business vehicle (e.g., a new or rebuilt engine or transmission) are capital expenditures and are recovered
through depreciation.
Tools– Amounts spent for tools and equipment used in your business are capitalized unless they are deductible under Section 179 or are deductible expenses because the tools have a life expectancy of less than 1 year or their costs are “minor.” For example, a $500 table saw must be capitalized unless it is qualifies for a Section 179 deduction and it is desired to use Section 179 rather than depreciate it.
Heating equipment – The cost of repairing a leak in a Freon line and recharging Freon is a deductible expense. The cost of changing from one heating system to another is a capital expenditure. Replacement of a failed compressor must be capitalized.
Roof – The cost of maintaining or repairing an existing roof is a deductible expense, but the cost of re-shingling a roof is a capital improvement.
Cost Recovery
Although you generally cannot take a current deduction for a capital expenditure, you may be able to recover the amount you spend through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able to recover your capital expenditure. Depreciation is the method of most interest for rental property owners.
Because costs of capital improvements are added to cost basis of the property, you will need to know the cost of improvements when you sell your property in order to minimize income taxes on a gain from its sale.
Depreciation
Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the
property.
You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You also can depreciate certain intangible property, such as patents, copyrights, and computer software. Land cannot be depreciated and remains part of the cost basis.
To be depreciable, the property must:
- Be property you own,
- Be used in your business
or income-producing activity, - Have a determinable useful
life, - Be expected to last more
than one year, and - Not be excepted property.
You are considered as owning property even if it is subject to a debt. Therefore, items purchased with a credit card qualify.
If you use the property to produce income (investment use), the income must be taxable. You cannot depreciate property that you use solely for personal activities. For property that has both business and personal use, only the business use percentage of the basis can be depreciated each year.
To be depreciable, your property must have a determinable useful life that extends substantially beyond the year you place it in service. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses
its value from natural causes.
There is certain property that cannot be depreciated even though it meets the above criteria. For example, you cannot depreciate property placed in service and disposed of in the same year.
The IRS provides for different methods of calculating depreciation, assigns useful lives for a variety of categories of depreciable items, and specifies recovery periods for each category. As examples, a new computer would usually have a
recovery period of 5 years, software 3 years, office furniture 7 years, a residential building 27.5 years, and a commercial building 39 years.
You begin to depreciate your property when you place it in service for use in your trade or business or for the production of income. You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first.
Property is considered placed in service when it is ready and available for a specific use, whether in a business activity, an income-producing activity, a tax-exempt activity, or a personal activity. Even if you are not using the property, it is
in service when it is ready and available for its specific use.