Capital Expenses Defined and Explained
What are Capital Expenses?
Businesses invest money in several types of investments. A business can purchase or build a new building, or it can buy new computer equipment or upgrade machinery and other technology to make the business more productive. A business can also purchase vehicles for sales people, executives, or for transporting products or providing services.
All of these investments are in capital assets, and the expenses are the yearly costs of purchasing these assets.
Capital Expenses or Expenditures are payments by a business to acquire or improve long-term capital assets, like buildings and equipment. Capital expenses are significant purchases that a business makes as an investment.
To explain this concept in a different way, the purchase of a capital asset adds to the value of the business. The value of the asset increases the owner's net worth, but the expense of paying for the asset increases the owner's liability.
Assets lose value over time, reducing the value of the business. This loss in value is depreciation.The cost of these capital expenditures is depreciated (the term used is "capitalized") over a period of time equal to what is called the "useful life" of that business asset. For example, office equipment purchased for $10,000 might be depreciated over 5 years, with $2,000 taken as a capital expense each year. (There are some ways to accelerate depreciation to get the tax benefit of the expense sooner. Talk to your tax professional about this.)
Some accounting specialists also include intangible assets (like patents, trademarks, and copyrights) in the category of capital expenses. These assets are amortized, a process that is similar to depreciation.
Are Maintenance Costs Capitalized?
Costs to maintain a capital asset, like a piece of equipment, in working order and in its current condition are not considered capital costs or expenses.
These are ordinary business expenses. called operating expenses. But the cost of repairing a piece of equipment to improve its condition adds to its value, so that's a capital expense. As you can see, it's tricky to determine operating costs vs. capital costs, and you should get your tax professional involved with this one.
Note that although land is a capital expense, it does not decrease in value and it is deemed to have an indefinite value, so it is not depreciated.
What are Operating Costs?
The opposite of capital expenditures are operating costs. Capital expenses are not used for ordinary day-to-day operating expenses of a business, like rent, utilities, and insurance.
Another way to consider capital expenses is that they are used to buy and improve assets that have a useful life of more than one year.
For example, if you buy office supplies for your business, that purchase is an operating expense, because office supplies don't typically last more than one year (although you may have those boxes of staples lying around for a long time). On the other hand, if you buy office furniture, it is expected that it will last longer than a year, so you are buying a fixed asset , and that purchase is considered a capital expense.
Capital Expenditures and Taxes
Businesses usually prefer to take tax deductions for purchases of business assets currently rather than spread them out over time. But the IRS has strict rules on what costs can be immediately expensed.
For example, startup costs improve the value of a business, even though they are spent at the beginning. The IRS allows only a limited amount of startup costs to be expensed in the first year. The balance of these costs must be amortized (similar to depreciation). Read more about startup costs and taxes.
For tax purposes, capital expenditures are typically depreciated, but under Section 179 of the IRS code, under certain circumstances, some capital expenditures may be considered current operating expenses.
New legislation (2015) allows more generous depreciation benefits to businesses for purchase of capital assets.
Read this article about the PATH Act of 2015 to see details on bonus depreciation and Section 179 deductions.
The sale of capital assets results in a capital gain or loss, depending on the basic value of the asset and its sale price. Capital gains and losses are taxed at a different rate than operating income.