Capital Expenses and Your Business Taxes
Capital expenses are money a business spends on certain assets of the business each year both for the cost of the assets and their upkeep. These expenses are deductible business expenses, but in a different way from other business assets.
What is Capital?
First, some definitions:
Capital is assets (things of value) bought by a business to make the goods and provide the services it sells. Capital assets can include cash, real estate, inventory, equipment, and vehicles.
To "capitalize" means to spend money on capital assets rather than expenses (continuing costs, like rent). The IRS requires costs of buying capital assets to be capitalized, and this means spreading the cost over time instead of taking it as an expense in the year the asset was bought.
Capital Assets and Capital Expenses Explained
Here's how capital expenses work: Businesses invest money in several types of assets (things of value), like a building, computer equipment, or office furniture. The business might also spend money to upgrade machinery and other technology to make the business more productive. A business can also purchase vehicles for salespeople, executives, or for transporting products or providing services.
All of these high-value items are called capital assets. Capital assets are property owned by a business. Common types of capital assets are buildings, land, equipment, and vehicles. Some accounting specialists also include intangible assets (like patents, trademarks, and copyrights) in the category of capital expenses.
Capital Expenses or Expenditures are payments by a business to buy or improve long-term capital assets. Capital expenses are significant purchases that a business makes as an investment. Taking expenses on capital assets is called "capitalizing."
To explain this concept in an accounting context, 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.
Capital Assets and Depreciation
Assets lose value over time, reducing the value of the business. This loss in value is depreciation. Depreciation is an expense for a business, but it's considered a non-cash expense because it doesn't have to be paid for with cash. 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.
The Tax Cuts and Jobs Act (2017) allows more generous depreciation benefits to businesses to buy capital assets. These benefits are in accelerated depreciation that allows a business to take more expenses in the first year of owning and using an asset. Accelerated depreciation benefits are in two types:
- Section 179 deductions, which increase your first-year deduction total of $1 million for buying certain business assets, with an annual limit of $2.5 million. After 2018, the limits are indexed to inflation. This deduction is for assets placed into service (used) in that year.
- Bonus depreciation for property bought and placed into service after September 27, 2017 and before January 1, 2023. This depreciation is in addition to any Section 179 deduction.
Accelerated depreciation is complicated. Before you buy business assets, check with your tax professional to discuss the possible tax implications of your purchase.
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 which costs are operating costs and which are capital costs. You should get your tax professional involved with making these decisions.
What are Operating Costs?
The opposite of capital expenditures is 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. As noted above, the IRS usually wants the costs of buying capital assets to be capitalized and spread out.
Business Startup Costs as Capital
You might think that startup costs could be taken as an expense of beginning a business since they are spent at startup. But the IRS says these costs improve the value of a business. Your business can deduct up to $5,000 in startup costs and $5,000 in costs to set up your business legal structure in your first year of business. The rest of these startup costs must be amortized (similar to depreciation), meaning they must be spread out over time. 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.
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.