Examples of Capital Expenditures

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Rahul Gupta

CA Final Student

1785 Points Joined February 2008

Examples of Capital Expenditures

To assist you with your deduct-or-capitalize analysis, we've put together the following list of items that the IRS or the courts have determined to be capital expenditures under certain circumstances.

abstracts of title costs
appraisal costs paid in obtaining possession of premises
asbestos removal costs
author's publishing costs
basement repair and waterproofing
boiler patching and welding costs
burglar alarm installation charges
business facility improvement costs (for example: waterproofing; replacing a roof; planning, designing, and constructing an addition; remodeling costs)
cable replacement costs upon sudden failure
copyright development costs
credit card, membership fees
display cases, remodeling costs
drainage costs
electric wiring, costs (new wiring, replacement, and rearrangement)
electrical system replacement costs
Federal Communications Commission (FCC) license preparation fees
fire escapes
flood protection costs (such as costs of raising floors, or rearranging bins)
insulation costs
irrigation system costs
merger negotiation costs
mutual fund setup costs incurred by investment advisors
office, cost of changing location and equipment
package design costs
performance bond premiums
Security Exchange and Commission (SEC) statement preparation cost
settlement costs for threatened lawsuit
well (water) costs
zoning change costs that increase the value of property beyond the tax year

Warning

Remember that the same item that was a deductible expense to one taxpayer might be a capital expenditure to another.

That's mainly because the deduct-or-capitalize question does not just involve what was purchased, but also whether its benefits will be expected to last for more than one year. If two taxpayers use an identical item in different ways in their businesses, the item may represent a capital expenditure to one, but a currently deductible expense to the other.

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Rahul Gupta

CA Final Student

1785 Points Joined February 2008

What, Exactly, Is a Capital Expenditure?

The most common type of capital expenditure occurs when you purchase or otherwise acquire any asset that will benefit your business for more than one year. New equipment, a car, computer, office furniture, or even business real estate are the things that most commonly come to mind when you hear the words "capital asset."

Expenses that add to the value or useful life of an item of property also are considered capital expenditures. If you have a capital expenditure that pertains to a particular asset in some year after the asset is purchased, you must treat the expenditure as a separate asset and depreciate it under the rules applicable to that type of asset in the year you place the expenditure into service.

Example

In 2000, you purchase and begin using a business building which does not have central air conditioning. In 2001, you install a new central air system, which increases the value of your property. You must depreciate the system over the course of 39 years from its installation, which is the same length as the recovery period that applies to nonresidential buildings in 2001.

In contrast, an expense that keeps an asset in an ordinarily efficient operating condition and that does not add to its value or substantially prolong its useful life is generally considered a currently deductible repair or maintenance expense.

Deciding whether a particular item should be classified as a capital expenditure or as a currently deductible expense is not always easy, particularly if it's debatable whether the expense represents a repair, or an improvement to a capital asset.

However, over time, the IRS and the courts have classified, on a case-by-case basis, some categories of items commonly considered to be capital expenditures, which we provide as a guide.

Some special rules. In some cases, the tax laws depart from the general deduct-or-capitalize analysis by providing specific rules that govern how you may or must treat certain expenditures.

For small business owners, the most commonly applied of these rules are:

an expensing election that allows you to deduct rather than to capitalize a specified amount of your costs in acquiring certain business equipment
amortization of startup costs, including those associated with organizing a corporation or a partnership
an election to capitalize rather than deduct taxes and interest you pay to carry or develop real property or to carry, transport, or install personal property

Rahul Gupta

CA Final Student

1785 Points Joined February 2008

Nondeductible Capital Expenditures

One of the principles underlying the tax rules for deductions is that your income for the year should be offset by only those expenses that contributed to earning that income.

Example

If you add floor space to your facility or purchase a new delivery vehicle, you've acquired an asset that will benefit your business for a number of years. If you were allowed to deduct the full cost of such an asset in the year you acquired it, you'd effectively be understating your income during that first year and overstating your income during all the subsequent years that you use the asset in your business.

It may seem as though this shouldn't really be a problem, because everything would come out even in the end. However, what would have happened from the government's perspective is that you would have reduced your taxable income inappropriately in the year of acquisition and deferred the payment of some income taxes, which is not something the IRS usually likes to allow.

So, instead of letting you currently deduct your outlay for items of a more permanent nature (that is, items that will benefit your business beyond the current year), the tax rules provide that such expenditures generally must be capitalized.

What does it mean to "capitalize" an expense? Well, apart from the fact that it means the expense is not fully deductible this year, the act of capitalizing an expense is just an exercise in bookkeeping. The asset becomes a capital asset, against which you can take depreciation deductions each year.

For now, let's just say that for tax purposes, you'll eventually recover the benefits of a capital expense through (1) annual depreciation deductions for the property and/or (2) a reduced amount of taxable gain or an increased amount of taxable loss when you sell or otherwise dispose of the property.

Although these two results are helpful, they are usually not as good as a current deduction in full for the expenses paid. Unfortunately, you normally won't have a choice as to how to treat a given expense. With certain exceptions, the tax rules specify whether an expense must be capitalized or is deductible.