The Internal Revenue Service uses a complex definition to identify capital expenditures (assets). A capital expenditure is not deductible as an expense in the tax year purchased; the taxpayer or entity must use depreciation, amortization or depletion to obtain deductible value on the entity’s return. This article is an introduction to the Internal Revenue Service’s definition of a capital expenditure.
In general any purchase that improves the value of real estate or restores the value of real estate is considered a capital expenditure. In addition, any purchase made to acquire or produce property (personal or real), tangible or intangible, that facilitates a change in the taxpayer’s or entity financial structure is considered a capital expenditure. The entity must comply with certain regulations when documenting this expenditure. There are some exceptions to the capital expenditure rules. These include the de minimis rule and safe harbor rule for small business taxpayers.
The following sections explain the above in more detail.
Real Estate Improvement
This is most common form of a capital expenditure (asset purchase) in larger operations. As a business matures and grows, it is not uncommon for the entity to purchase land and build a facility for operations. The site development work, the construction of the building, the landscaping work and other outside structures are referred to as improvements. The IRS considers this outlay of money as a capital expenditure. The governing law and regulations are found in Section 263(a) of the Internal Revenue Code and the corresponding regulations, interpretations, memorandums and determination letters.
One of the underlying principles of the definition is a future benefit. Based on history and case law, the taxpayer must demonstrate the deductibility of the expense in the current tax year to place the full cost onto the entity tax return. This is a difficult standard to meet for asset purchases related to real estate or for equipment.
Another principle used in the definition is ‘… prolonging the useful life of the asset.’ Therefore, any betterment or modification to the structures or equipment that enhances its functions or extends the production life cycle is considered a capital expenditure.
In addition, the purchase of the raw land is also considered a capital expenditure. However, land is not expensed to the income statement via depreciation, or under any other means. This is due to the inexhaustible use of this particular asset. It will still be here long after we are gone or the building crumbles to the ground. Therefore, the asset is maintained on the books (balance sheet) at its original purchase price indefinitely. The only exception to this rule is when land is purchased for mining purposes (another article for later).
Purchase of Property
As explained above, land is considered purchase of real property and is recorded as a capital expenditure on the books of the company. In addition, companies purchase equipment, furniture, fixtures (art work, custom made reception areas etc.) and office equipment. In the eyes of the IRS, these are also considered capital expenditures. By definition, application of Section 162 (definition of expense) and Section 263 (definition of capital expenditure) is founded in the principle of expending money to ‘acquire, produce, or improve tangible property’.
To complicate matters, the IRS also considers the associated costs to acquire the financing for the capital outlay as a capital expenditure. These forms of costs are often referred to as loan costs and are intangible in nature. Intangibles are expensed to the income statement using an accounting process referred to as amortization. Read What is Amortization? to gain a better understanding of this term.
There are many different regulations in regard to capital expenditures, so let’s start out with the core regulations and then I’ll get into the marginal items.
- Written Accounting Procedures – your business should have written accounting procedures identifying those items treated as an expense. In general the procedures should state a maximum dollar limit for item to be expensed and in addition the item must have a useful life of less than 12 months. This correlates with Generally Accepted Accounting Principles definition of an expense verses a fixed asset. It is my opinion that any purchase in excess of $500 and having a useful life in excess of 12 months is a capital expenditure.
- Generate Financial Statements – if you generate regular AUDITED financial statements, you are allowed to use a higher deductible limit of $5,000 per item as an expense instead of capital expenditure treatment. If you generate financial statements that are not audited, the limit is reduced to $500 per item.
- Annual Election – the election to treat the items as de minimis is an annual election made with the tax return.
De Minimis Rule
The general rule is that any capital expenditure up to 0.1 percent of gross receipts or up to 2% of the total depreciation amount is deductible on the tax return in the current tax year based on the value as determined by the financial statements.
Example – if your gross receipts for year is $2.3 Million and your depreciation on your financial statements is $135,000 then your de minimis deduction is either $2,300 (.1 percent of $2.3 M) or $2,700 (2% of depreciation). Therefore, the taxpayer will elect to use the $2,700 as the deduction related to the de minimis rule.
This rule is designed for real estate maintenance and repair issues. Basically, if your business has less than $10,000,000 in gross receipts, you are allowed to expense up to $10,000 or up to 2% of the unadjusted basis of the building whichever is less. This is contingent upon the total costs of maintenance and repairs not exceeding the $10,000 threshold. If the total costs exceed this dollar threshold, then the taxpayer must apply the general rules related to Section 263(a).
Summary – Capital Expenditures
A capital expenditure is defined as an outlay of funds similar to the definition as found in Generally Accepted Accounting Principles. The primary tenet of the definition is acquiring a future benefit beyond the current tax year. In general any expenditure that improves real estate or purchases of tangible or intangible (patents, copyrights, loan costs, franchise rights, etc.) that enhances the earning power of the taxpayer into the future or extends the future is considered a capital expenditure. The IRS uses the phrase ‘… acquire, produce or improve tangible property’.
In general, items purchased up to $500 may be expensed on the return provided you meet certain standards including written accounting policies and procedures and you qualify as a small taxpayer (less than $10,000,000 per year in gross revenue). If you produce audited financial statements then you may deduct up to $5,000 per year for each item as an expense.
For additional clarification as it relates to the non-standard types of purchases, review Chapters 7 and 8 of Publication 535 from the Internal Revenue Service. Act on Knowledge.