Current vs. Capital Expenses

Wednesday, May 7, 2008

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When you may deduct a given expense depends in part on whether it's 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're 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.

Generally, current expenses are considered the everyday costs of keeping your business going, such as the rent and utility 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, can't be deducted in the same way as current expenses. Since they are expected to generate revenue in future years, asset purchases are treated as investments in your business. They must be deducted over a number of years, or capitalized, as specified in the tax code. Theoretically, this 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 exception to the rule above is Section 179, which allows a small business to write off in one year most types of its capital expenditures, up to $250,000 in 2008, provided the investment is less than $800,000. That figure is an aggregate—you can buy any number of pieces of equipment to take the deduction, but once you go past that number, depreciation applies. Some assets don't qualify for this deduction, including real estate, inventory bought for resale and property bought from a close relative.)

The deduction taken over a number of years is usually called depreciation, but in some cases it is called an amortization expense. All of these terms 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. All businesses are affected by these provisions.

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,
* 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. For 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.

To learn more about the differences between current and capital expenses, consult your accountant, tax professional or financial advisor. Special thanks to legal and business information provider Nolo.com for its help in preparing this article.
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