Current vs. Capital Expenses

When you may deduct a given expense depends in part on whether it is considered a current or capital expense.

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.

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 -- 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.

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 Section 179. A small business can write off in one year most types of its capital expenditures, up to a grand total of $112,000 in 2007 (subject to a phase-out after you reach $450,000 or more of eligible Section 179 expenditures in one year). 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, unless they don't have enough business income to offset the Section 179 deduction (the Section 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 a repair expense. In 2007, 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.

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