Capitalization , Amortization, and Depreciation
In general, expenses are deductible if allowed by a specific code section. Capital
expenditures, in contrast, are not deductible; instead, they must be added to the basis of an asset.
From there, they may – or may not – result in future depreciation or amortization, depending on
the type of asset.
For example, the cost of land must be capitalized and is never subject to
depreciation or amortization recovery.
In contrast, five years worth of pre-paid insurance must
also be capitalized; however, it may then be amortized over the five-year life.
These very simple rules are subject to some controversy and require much refinement.
The difference between an expense and a capital expenditure is sometimes obvious.
example, the replacement cost of a single shingle blown off a roof by a hurricane is clearly an
expense – and thus not subject to capitalization - for two reasons.
First it is minor – and thus not
worth the process of capitalization and depreciation. Even though the shingle itself may actually
last many years, depending on the remaining life of the roof, the minor cost is not worth the
Second, its replacement does little to change or extend the life of the main
asset – the roof.
Hence it is just a short-term, minor repair and gives rise to the allowance of a
deduction under section 162 as an ordinary and necessary business expense (assuming, of course,
the roof was on a building used for a trade or business).
For accounting purposes, we would
debit an expense account – repairs – and credit a payable or cash account to reflect the payment
or the creation of a liability.
At the other extreme, an entire new roof will last some twenty years and its costs must
surely be spread over that time frame.
The process of doing so is called capitalization of the
expenditure and depreciation of the asset.
Technically, for accounting purposes, we would debit
an asset account for the cost and credit either a payable or cash account to reflect the payment or
creation of a liability.
The asset account may be a separate asset -
called new roof – or it may
result in an adjustment to the basis of the building.
As illustrated below, however, many fact patterns do not so clearly involve a simple
repair or an obviously new long-term asset.
They can be very close to the line delineating repairs
versus capital improvements.
As we will see, that line can be both fuzzy and a moving target.
Courts have mostly resolved it using a facts and circumstances method of analysis.
Other issues of capitalization involve the various accounting methods.
As a general rule
cash method taxpayers may deduct expenses when paid.
As a general rule, accrual method
taxpayers may deduct expenses at the later of incurrence under the “all events” test and
economic performance pursuant to section 461(h). Each of these general rules, however, is
subject to regulations under section 461 and 263 plus several important appellate decisions.
Some of these authorities have been, at least historically, controversial.