Is This Your Situation: Confused About Capitalization and Safe Harbor

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Whenever you spend money on your business, the expense is either deducted on your federal tax return in the year it is incurred or depreciated over time. Here’s how to tell what to do.

Deductible costs: These are the day-to-day costs of operating your business, such as rent, insurance, maintenance and office supplies. The IRS lets you deduct all these “ordinary and necessary expenses” during the taxable year they are incurred.

Capital costs: These are payments you make to acquire or improve your building and equipment. These costs, such as upgrading an HVAC system, are considered business investments that add to the value of your asset. Capital costs are depreciated on tax returns over the course of their “useful life” as determined by the IRS. The useful life of a laptop, for instance, is three years, while the useful life of telecommunications equipment is seven years. Sometimes, intangible assets such as patents and trademarks are considered capital expenses.

It seems straightforward. But, in fact, determining whether a cost must be capitalized over X years isn’t as easy as it looks. And, to make accounting even more fun, the IRS has a “de minimis safe harbor election” that lets you deduct expenses that you otherwise would be capitalizing. Let’s look at that.

De-what?

The de minimis (Latin for “concerning the smallest things”) safe harbor is a yearly tax return election that lets you deduct expenses for tangible property that costs below a certain threshold. Essentially, it gives taxpayers an immediate but limited tax break on items that would otherwise take many years to depreciate.

The IRS has been busy lately increasing the threshold from $500 to $2,500 for businesses that don’t have an audited financial statement, something many small businesses do not have. This means that if your small business bought, for example, a computer for $2,499, you might be able to deduct the entire amount on that year’s tax return, instead of over many years.

For businesses that maintain an AFS, the threshold continues to be $5,000.

De minimis safe harbor is considered a good thing because taking immediate tax deductions simplifies record keeping and increases tax refunds.

How to make de maximis of your de minimis

  • Make sure you expense all tangible property costs below $2,500.
  • Since the de minimis safe harbor threshold can be applied to any and all tangible property purchases below $2,500, make sure your bookkeeping staff applies the threshold to each qualifying item.

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