Tax law limits your business deductions in two main ways: amount and timing.
Capitalization is a limitation on your tax deductions that only affects timing, not the amount.
However, even though you do not get an immediate deduction, you can usually recover the full amount of the expense over a period of multiple years.1
The primary methods of cost recovery for capitalized expenses are:
Sale of the asset
You can also recover your cost by selling the asset. This works because capitalization increases the of your business asset.2 Therefore, when you sell (or otherwise dispose of) the asset, you recognize less or more .
Note that for personal assets, capitalization works to your advantage because it provides you the option of recovering your cost through resale of the asset. (You cannot normally take deductions for personal expenses.)
Property to Capitalize
Here are the five main types of expenses you have to capitalize:
Improvements to property
Property you create
1. Long-Term Property
You must capitalize the cost of property you purchase if:3
The property has a useful life of more than one year, or
The property produces a benefit that will last more than one year
Thus, you have to capitalize many of your big-ticket expenditures, like vehicles and buildings.
You have to capitalize the cost of some expenses to improve or fix assets you already own if that improvement:4
Lengthens the time you can use the asset,
Adapts the asset to a different use, or
Adds value to the asset.
Example 1. If you convert your warehouse into a showroom, you have to capitalize the costs of that conversion.
Example 2. If you simply repair your warehouse and keep it in a normal efficient operating condition, you can deduct the costs of the repairs.
3. Property You Create
You also have to capitalize the cost of the tangible property that you create or produce.5
If you average yearly gross receipts of $10,000,000 or more, you have to capitalize the cost of property that you hold for resale.6
5. Start-Up Costs
You capitalize the costs you incur to start a new business, including costs to train new employees and advertise for the opening of the business.7
1 See, e.g., Reg. Section 1.263(a)-2(h)(1).
2 IRC 1016(a)(1).
3 Reg. Sections 1.263(a)-2(d); 1.162-3(c).
4 Reg. Section 1.263(a)-3(d).
5 IRC Section 263A(a)(1) and (b)(1).
6 IRC Section 263A(a)(2).
7 IRC Section 195.