Capital expenses are costs associated with business assets, like machinery, buildings, and vehicles. Your business can deduct these costs, but in a different way from usual expenses like rent, insurance, and supplies.
This article explains the difference between capital expenses and operating expenses and how the former can affect your business taxes.
What Are Capital Expenses?
Capital expenses are costs associated with your investment in your business. In other words, they are expenses for capital assets. Capital assets are things of value bought by a business to make the goods and provide the services it sells. These assets are expected to last longer than a year, like buildings, furniture, equipment, and vehicles,
To "capitalize" means to spend money on capital assets, a different method from deducting the cost of operating expenses (continuing costs of running your business). The Internal Revenue Service (IRS) requires costs of buying capital assets to be capitalized by spreading the cost over time instead of taking it as an expense in the year the asset was bought.
How Do 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 increase productivity. A business can also buy cars for salespeople, executives, for transporting products, or for providing services.
In accounting terms, buying a capital asset adds to the value of a business. This additional value increases the owner's net worth, while the expense of paying for an asset increases the owner's liability.
Startup Costs as Capital Expenses
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, which means they are considered as capital expenses.
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 several years.
Capital Expenses vs. Operating Expenses
Operating expenses are another type of business expense and are handled differently than capital expenses for tax purposes. They are the day-to-day expenses needed to operate a business, like rent, utilities, insurance, and payroll.
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.
In another example, 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 operating expenses. But the cost of making changes to a piece of equipment to improve its condition adds to its value, so that's a capital expense.
|Quick Guide to Operating Costs vs. Capital Costs|
|Costs for capital assets||Operating Expense||Capital Expense|
|Loan payments on capital assets||x|
|Most startup and organization costs||x|
|First $5,000 of startup and organization costs||x|
|Cost of vehicle||x|
|Tools that cost $200 or less||x|
These deductions have qualifications and limits. See IRS Publication 535 Business Expenses for more details.
Capital Assets and Depreciation
Capital 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.
The cost of buying land is a capital expense, but it doesn't decrease in value and it has 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, which allows a business to take more expenses in the first year of owning and using an asset. Accelerated depreciation benefits are categorized in two ways:
- Section 179 deductions: These are for assets placed into service (used) in the tax year. For tax years beginning in 2020, the maximum section 179 expense deduction is $1,040,000, reduced if the section 179 property placed in service during the year is over $2,590,000.
- Bonus depreciation: This is a 100% additional first-year depreciation deduction 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.
Depreciation is complicated. Before you buy business assets, check with your tax professional to discuss the possible tax implications of your purchase.
Frequently Asked Questions (FAQs)
When does an auto expense become a capital expense?
Vehicles, including cars, trucks, SUVs, and other vehicles used for business purposes are depreciated as capital expenses.
Costs for the use of a vehicle, except depreciation, are deducted as business expenses. However, only the business use of the vehicle can be included as a business operating expense.
How do I take a tax deduction for capital expenses?
These expense deductions, including depreciation, are recorded on the tax form of the business, depending on the business type. For Schedule C used by many small business owners, operating expenses are recorded on the "Expense" part of the form. Depreciation expense for the year for all assets owned by the business is recorded on IRS Form 4562 Depreciation and Amortization and is added to the business tax return.
How much capital expenses can be deducted by a business?
There are limits on the amount of Section 179 deductions a business can take in a year, including a limit to the business taxable income for the year and limits for deductions on passenger vehicles, and a $25,900 limit on the Section 179 deduction on a sport utility vehicles.
In addition, there are limits on the amount of disallowed Section 179 deductions from one year that can be carried over to a future year.