Accountants are weird. They use funny words and use lots of spreadsheets. One common word is Capital Improvements. Similar words that they use to describe the same things: Capital Assets, Fixed Assets, Property, Real Estate, FF&E (Furniture, Fixtures, & Equipment). In the accounting tax world, all of these terms describe something with an economic benefit beyond one year.
If something lasts longer than a year, from a computer to a piece of land, we treat it differently. This gets very confusing for entrepreneurs, because you are generally thinking of "it's money I spent, what difference does it make?" Then you throw in the fact that most things that last longer than a year are often paid for using borrowed money, and you have confusion on steroids.
Items that last longer than a year are generally depreciated for tax purposes. As an aside, tax accounting is only ONE method of accounting, but for your small business purposes, usually the only one you care about. So items are depreciated over a period of time, which is a fancy way of saying "spreading the cost over time". If you think about it, it makes total sense. A building that you buy has many years of use, so matching that cost to when you "use" it, is generally understandable.
So you take a fraction of the purchase price and recognize (depreciate) the expense over time. Simple enough. But the IRS has lots of rules depending on the type of asset. For general purposes, the IRS classified these items into depreciation groups as such:
3-Year Property: Examples include over the road tractors and race horses
5-Year Property: Examples include computers and cars
7-Year Property: Examples include office furniture and agricultural machinery
10-Year Property: Example is water transportation equipment
15-Year Property: Land Improvements
20-Year Property: Farm buildings
27.5 Year Property: Residential real estate
39-Year Property: Commercial real estate
Understand, these depreciation lives only generally follow their useful lives, but these are the rules Congress has given us.
Of course there are exceptions to the rules, right? Some of the most popular are:
Section 179: Most tangible personal property and qualified real property can accelerate their depreciation using this method. For 2020 the limit was $1,040,000.
Bonus Depreciation: Available through the 2022 tax year, this method allows you to depreciate/expense 100% of unlimited qualified property. Generally more limited types of property are eligible compared to Section 179.
Cost Segregation: Used when you have a property like real estate that has multiple types of property. Identifying and depreciating items allows for faster expensing.
Sale of Items
Sometimes, you sell these items, and that triggers a taxable event. Generally speaking, you pay tax on the difference in the amount you receive less what you haven't already depreciated (sometimes called basis). These transactions are called capital gains, and are subject to a whole different set of rules and rates than "ordinary" income.
When you sell an item that you have depreciated, often there is what is called recapture. A simple example. You buy a piece of equipment for $100,000, and sell it 3 years later for $75,000. Let's say you didn't take any of the bonus depreciation items mentioned above and had only depreciated $60,000 during those three tax years. So you have a basis of $40,000 ($100,000 purchase price less $60,000 in depreciation). So for tax purposes, you have a gain of $35,000 ($75,000 sale price, less $40,000 in basis).
How much of the $35,000 is "recapture" of the depreciation? Why do you care? Amounts that are recapture do not receive the preferential treatment of capital gains. In our example, $35,000 is recapture. You'll have to email me for the details. You're just going to have to trust me.
How to depreciate Capital Improvements and other personal and real property is not a simple process. You must plan over multiple years to ensure you don't have unintended consequences or surprises. Don't try this at home!
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