Capitalization
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.
When you capitalize a business expense, you cannot deduct the full amount of the expense in the tax year in which you incur the expense.
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
Cost Recovery
The primary methods of cost recovery for capitalized expenses are:
Sale of the asset
With depreciation and amortization you deduct a percentage of the expense each year until, eventually, your deductions add up to the full cost of the asset.
You can also recover your cost by selling the asset. This works because capitalization increases the basis of your business asset.2 Therefore, when you sell (or otherwise dispose of) the asset, you recognize less capital gain or more capital loss.
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:
Long-term property
Improvements to property
Property you create
Inventory
Start-up costs
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.
2. Improvements
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.
See the glossary write up on repairs versus improvements for more information on this.
3. Property You Create
You also have to capitalize the cost of the tangible property that you create or produce.5
For more on this, see the glossary write up on the uniform capitalization rules (UNICAP).
4. Inventory
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
For more on this, see the write-up on start-up expenses.
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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.
